What factors should the income investor consider? Just going for the highest-yielding instrument is likely to get you into trouble very quickly. You need to look at a variety of factors, as I've outlined in the list below.
1. The risk/reward trade-off
The riskier an asset, the higher its potential return or yield. A simple way of understanding this is to look at sovereign debt – governments with a fantastic long-term record for reliability can get away with paying a fraction of the rate charged to riskier emerging market governments. That risk spread can amount to many hundreds of basis points (basis points are one hundredth of a single percentage point). At the height of the market panic back in 2008, risky corporate debt (also known as high yield) was trading at a difference of more than 10 per cent a year or 1,000 basis points in yield terms over safer, investment-grade corporate debt. That margin – like that for developed/emerging sovereign debt – has now narrowed very appreciably with some analysts worrying that the 'spread' has become much too narrow considering the extra risk.
2. Frequency of payment
One of the great attractions of many high-street savings accounts is that they can pay interest monthly (although not always – check the small print as many of the instant access savings accounts with very high rates only pay annually). That monthly frequency often comes at a cost with slightly lower interest rates. Many dividends are either paid quarterly or twice yearly while some bonds only pay annually.
3. Alternatives to bonds
Income can be derived from a multitude of different sources and not just traditional bond-based structures such as corporate or sovereign debt. Shares or equities can pay a very rewarding yield as can structures that exist between bonds and common stock equity, such as preference shares.
4. Tax treatment
Preference shares (prefs) are issued by various financial institutions and they traditionally pay out more in income than government bonds (also known as gilts) and investment-grade corporate bonds. Crucially, these prefs also pay tax before they issue a payment to investors – for basic-rate taxpayers that means that any income you receive is net of tax.
5. Current value versus redemption value
With many fixed-income securities the current value of the bond, for example, could be more or less than the final value you receive when the bond winds up or redeems. This matters hugely as it affects the yield you receive. If the fixed-income security trades at above the redemption price and you hold to maturity, you might trigger a capital loss and that needs to be accounted for in the yield return.
6. The pecking order and counter-party risk
Many of the most interesting income producing assets tend also to be more risky – an echo of our first point. They also tend to occupy a fixed place in the hierarchy of payments in the event of a bankruptcy. Pibs and prefs, for example, rank behind corporate debt but ahead of equity. This pecking order is also applicable to collective fund assets but in a different way. Some exchange-traded fund (ETF) providers, for example, offer exposure to an index via derivatives-based structures that guarantee to make both the capital payment from any change in the index and the yield. It's a respected structure that in 99.99 per cent of the time presents no real risk, except when markets are in meltdown and you discover that the 'counter-party' guaranteeing that payment is actually Lehmans.
7. Timespan for income-based products
The general rule is that the shorter the period of time that you lend your money out, the lower the required interest rate or yield and vice versa. This rule generally holds true, but every once in a while the markets warp and an inverse relationship takes over. Also be aware that some fixed-income securities can be perpetual – ie, they have no due date for redeeming or being called and can carry on forever. Governments have been at this particular game for hundreds of years – UK Consols (originally issued in 1752 with the current 25 per cent Consolidated Stock issued in 1923) are perpetual government loan stock and have no set repayment date.
8. Inflation
Put simply, increasing prices on products, as measured by a major index such as the Retail Price Index (RPI), destroys the present-day value of your income. In most circumstances investors would want to be rewarded for higher inflation with higher yield – in the case of index-linked certificates and government bonds that relationship is an explicit part of the structuring of the bond and its payout. But most fixed-income securities have no explicit relationship to inflation.
9. Diversification
Diversification of risk and return is as crucial for income as it is for capital gains. If all your income-producing assets are tied up in corporate bonds, you should be asking your adviser some very awkward questions. A mixture of lower-risk assets such as government bonds or gilts could be a good idea alongside corporate bonds and riskier assets.
10. Value matters
Some bonds can be cheap and good value based on the reliability of their asset backing. Investors tend to forget that the capital price of gilts and bonds can vary enormously over time and that you can buy income-producing bonds at the wrong price even if it’s producing the right coupon. Equally, though, some assets such as high-yield bonds do trade at a sensible low price precisely because some firms do go bankrupt and fail to pay their lenders. Default is an ever-present and real risk in the world of bonds.
11.There is nothing that is risk free
Government bonds are not risk free – governments have and will continue to default on their debts.
All these factors should lead you to one simple conclusion: investing for income is every bit as difficult as investing for capital gains. You need to consider a range of factors, diversify risk and returns and do your research on the underlying structure that you're investing in.
To help you navigate your way through the maze of income-producing assets we've banded together a mix of assets into three risk-based bundles, ranging from a lower-risk bunch that includes government debt through to higher-risk, higher-yielding assets that are difficult to access for mainstream investors.
So be prepared to mix and match assets within and between the bundles to see what works for you.
