Income Investing: The Importance of Fixed Income

What is Income Investing?

Nobody wants another “entrepreneur” trying to sell their latest get rich quick scheme. We want investments designed to generate steady income—usually with an eye toward a secure retirement. In the stock market, we call this income investing.

Income Investing

One great “Get Rich Slowly” strategy is income investing.

Income investing involves buying securities that generally pay out returns on a steady schedule. That’s why we consider it “income”. Consider your paycheck deposited into your bank account every two weeks for example.

Bonds are the best known type of fixed income security, but the category also includes stocksstock and bond fundsExchange-Traded Funds (ETFs) and Real-Estate Investment Trusts (REITs).

The Internet and real estate bubbles have dominated the financial spotlight in recent decades, fueling the get-rich-quick crowd. But that doesn’t mean that income investing has fallen out of favor. Far from it.

In this course, we’re going to take you on a tour of the most common income-investing options available. But first, let’s talk about why income investing is such an important part of your financial arsenal.

The Importance of Fixed Income

Whether you love your work or not, Father Time will eventually catch up with you. When that happens, you’ll need other sources of income to cover living expenses.

For some, the idea of not being able to spend their money freely is a scary proposition. But living on a fixed income is far from the end of the world. In fact, if you invest wisely, you’ll realize that adding fixed income to the mix is essential.

Mainly, no one wants to live with the fear that retirement is somehow going to lower your standard of living or quality of life. And for many that’s a real threat—especially now that it’s harder and harder to find companies that offer great pension or benefit plans.

That’s where fixed income investments come in: providing you with a reliable income stream with minimal risk.

Fixed income investing is relatively simple, with a select group of easy-to-understand options to choose from. Let’s look at the most common ones.

Bonds and Income Investing

income investing

You may know more about Barry Bonds or James Bond than the kind of bonds that are sold in financial markets around the world.

BOND LINGO AND BEYOND

A bond is always issued with a certain face amount, also called the principal or par value of the bond, commonly issued in $1000 increments.

Most bonds pay interest, which varies from bond to bond, and is usually paid out twice a year. For most kinds of bonds, that rate is fixed over the life of the bond, although the terms of some types of bonds aren’t.

The life of the bond is known as its maturity.

In reality, bonds are pretty easy to understand. When you buy a bond or invest in a bond fund, you’re buying debt. You basically become a banker, lending a government agency or company money. In return, you get a guaranteed interest payment, along with all of your original investment.

For example, let’s say a city needs to borrow money to build a dog park. They decide to raise the money by issuing Class A Doggie Bonds for $100 each. In exchange, the city promises to pay you $20 in interest on that bond over a certain period of time. When that time runs out, you get your $100 back as well.

Fixed Income Stocks

You might be asking yourself how something as risky as a stock could be considered part of the “fixed-income” universe. The answer starts with a “D” and ends with an “S”: You guessed it, DIVIDENDS!

Think of dividends as a form of rewarding shareholders for their faith and investment in a company. Usually every three months (or “quarterly”), companies will pay shareholders a percentage of their earnings.


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Dividends At Work

Companies pay out dividends as a percentage of the stock price.

Let’s say the Jeans Company pays a dividend of 2% and their stock price is $100 per share. The Jeans Company will pay a dividend of $2 per share. So if you own 200 shares of the Jeans Company stock, you’ll receive a dividend payout of $400.

Shareholders often have the options of either pocketing the dividends directly as cash, or reinvesting the dividends back into company stock. This means that, instead of taking your $400 in Jeans Company dividends and running, you reinvest it in the company and add more shares to your holdings. In this example, you’d be able to add 4 more shares of the Jeans Company stock ($400/$100).

Many dividend-paying companies offer shareholders the option of using a Dividend Reinvestment Plan (DRP), which automatically reinvests dividend payments into company stocks, commission-free.

Who's Paying Dividends?

You usually won’t find too many dividend-paying income stocks for companies that “stay ahead of the curve,” like computer or biotech firms. That’s because they need to reinvest their cash flow into ongoing research and development efforts. In exchange, shareholders’ can be rewarded by a higher stock price.

Dividend-paying stocks are usually found in companies with steady cash flows, meaning the money coming in and the money going out stays relatively consistent. They also tend to have less money going back into the company for R&D purposes. Industries such as utilities and basic materials consistently pay good dividends.

Like any stock, dividend-paying equities aren’t without risk; the price of these stocks rises and falls, but usually in a fairly narrow range. And once a company commits to paying dividends, management strives to keep those dividends steady or rising to gain investor’s confidence and attract more shareholders.

Income-Producing Funds: Mutual Funds vs. ETFs

income investing

Image courtesy of thestar.com

Income-producing funds bunch together a number of different types of fixed-income assets, spreading the risk so that investors don’t have to stake all of their bets on a single option.

Like chemists, fund managers try to mix and match the best fixed-income “ingredients” to produce the highest rates of return for investors. Sometimes these funds include 100’s or even 1,000’s of different fixed-income products under one umbrella.

Mutual funds are the most common way investors build fixed income portfolios, but exchange-traded funds (ETFs) specializing in income investments are quickly gaining popularity.

Just like with a mutual fund, you can buy shares in ETFs composed of different kinds of fixed income holdings—whether they’re municipal, state or federal bonds, stocks, U.S. Treasuries, or combinations thereof.

Unlike mutual funds, ETFs can be bought and sold in real-time just like stocks. They don’t require any minimum investment, and there is no sales fee (commonly called a “load-fee”) apart from the cost of a trade.

One way to avoid confusion about whether fixed-income ETFs or mutual funds are right for you, is by comparing how they’re performing. Many sources on the web continually update their monthly rates of return, including TheStreet.comForbes, and individual brokerage houses.

If you’re in the market for an income-producing investment, do the research, factor in the fees, and identify the funds you like best!

To REIT or Not to REIT?

Real estate investment trusts (REITs) are like hybrid plants—with the genes of both a stock and mutual fund spliced together. They trade like stocks, with their own ticker symbols, but when you invest in a REIT, you’re buying a group of different real estate properties.

Like income stocks, REITs pay out dividends. But unlike stocks, every REIT is required to pay out at least 95% of their earnings in the form of dividends.

If the value of the underlying properties in the REITs grows, so does the value of your investment in that REIT, which can add to nice, steady fixed returns.

REIT investments also diversify your portfolio with exposure to real estate without any of the high overhead it takes to buy and sell property, or any of the complex responsibilities of being a landlord. On top of that, they offer appealing tax advantages.

So why would anyone NOT want to own REITs?

Well, first of all, these factors don’t mean that REIT’s are a slam dunk. When a REIT’s property holdings decline in value along with the real estate market, their dividend payments and share price will decline as well.

REITs are also particularly sensitive to interest rates, as rising interest rates can take a bite out of their profits.

The dividends of some REITs don’t offer the same tax advantages of others.

You can get a nice snapshot of how REITs are performing by monitoring the Dow Jones All REIT Equity Index, which you can track under the symbol ^REI. For much more information, visit the website of the National Association of REITS (NAREIT).

Changing Landscape of Income Investing

Income investing used to be a matter of fluffing up your portfolio with some bonds and income stock funds, sitting back, and reaping slow, steady gains. The traditional approach, however, is no longer the go to.

“For income investors, a no-growth economy can be a positive,” stated Richard Lehmann (of no relation to the Lehman Brothers), who publishes the highly regarded Forbes/Lehmann Income Securities Investor Newsletter.

“The fact is most income securities are not dependent on growth or profitability. What I care about is that a company survives so that it continues to make its routine interest or dividend payments.”

In fact, dividend income investing is now very much in vogue. So far this year, dividend-specific ETFs are easily outperforming most other ETFs, accounting for eight of the top ten leading fixed income ETFs.

Lehmann says ETFs are the best way to income invest, “Not in long-term corporate bond or U.S. government Treasuries. The risks of a sudden reversal in rates is just too great. Puny yields and potential capital losses make them a terrible investment.”

The Get-Rich-Slow philosophy is clearly not a lackluster approach. Sure, slow and steady wins the race. But if you're collecting a regular stream of income as you go, that slow and steady race becomes a very attractive one.

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