An M&G guide to income investing

06/06/2019

Generating a strong and reliable income from your savings and investments is never exactly easy, but it is particularly challenging in the current era of ultra-low interest rates.

Glossary

For explanations of the investment terms used throughout this article.

View the glossary

In previous decades, it had been possible to earn relatively healthy returns from cash savings and by investing in assets perceived to carry very low investment risk, such as the bonds issued by developed western governments.

Since the financial crisis, however, these sources of income have largely dried up. Interest rates on cash savings held in banks and building societies have been very low – and falling – since western central banks lowered base lending rates to nearly zero.

Moreover, since the financial crisis, a ‘flight to quality’ among investors towards traditionally lower risk assets has driven up demand, and so the price, of mainstream government bonds. The yields on these bonds – annual investment returns as a percentage of the price paid – have been pushed lower, often well below rates of inflation, therefore cutting the income stream that investors receive.

Low government bond yields have had a direct knock-on effect on the retirement incomes secured by annuities, which guarantee fixed payments for life in exchange for handing over your pension savings.

Many people have sought to maintain an income stream from their savings by buying and holding assets chosen specifically for their capacity to deliver high and regular income payments. This strategy is known as ‘income investing’.

Which assets generate an income?

All the major asset classes – fixed income (bonds), equities (company shares) and property – can each deliver income for investors.

By definition, bonds are income-paying assets. Bondholders receive a fixed income in the form of a coupon – the regular interest payment by the bond issuer to bondholders for the life of the loan – so long as the government or company in question keeps up with its payments. 

The fact that coupons are fixed, sometimes for decades, means that they can be overtaken by inflation, reducing their real value to bondholders when they come to receive them. For this reason some bonds are index-linked, meaning the coupon will rise (and fall) in line with inflation, thereby protecting its value against potential erosion by inflation.

Like bonds, property investments also aim to deliver a regular income. The investor – who is essentially the landlord – leases out properties to tenants for an agreed rent over a fixed period. With commercial property, the leases typically run for five years. Again, the risk for investors is that tenants fail to pay their rent, leaving them without an income.

Equities, or company shares, can also deliver income through dividends. These are distributions of company profits that are typically paid out to shareholders on a regular basis, usually every three months.

The amount of money distributed to shareholders is always at the discretion of company directors, but many companies are committed to ‘progressive’ dividend policies, intending to maintain or grow their payouts each year. Investors should remember that challenging market conditions or company underperformance can, however, force companies to cut or abandon their dividends.

Is income investing right for me?

Investing for income can mean prioritising cash generation over capital growth.

Companies that are committed to paying out large dividends might, for instance, allocate profits to shareholders over reinvesting the money in their businesses, potentially stunting future growth. For equities investors, choosing the shares of established dividend payers over those of younger companies without a track record of paying dividends could therefore be a case of jam today, rather than tomorrow.

Depending on your circumstances, capital growth may be a greater priority than cash payments today if your goal is to build the value of your investments over the long term, perhaps for your future retirement.

However, income investing can even be an appropriate strategy for those investors taking a long-term view who do not need to take cash from their portfolio for many years.

The investment returns from an income-led approach can be reinvested, rather than taken as cash, unleashing a compounding effect. You can read more about the effect of compounding over the long term here. The longer you are investing for, the longer these earnings can work to deliver further returns and therefore the larger the total value of your investments at the point when you need your money.

Important information

When you're deciding how to invest, it's important to remember that past performance is not a guide to future performance, and that the value of investments can go down as well as up.  So how much your investments are worth and the income from them will fluctuate over time, and you may not get back the original amount you invested.

We are unable to give any financial advice, and the views expressed in this article should not be taken as any kind of recommendation or forecast. If you are unsure about the suitability of your investment, please speak to a financial adviser.