An investor’s guide to income

Investors undoubtedly want to see the value of their assets grow over time, but many also want to generate a regular income. That could be from a savings account, or investing in stocks or bonds, for example – or a combination of all three.

For the very risk averse, savings accounts are the usual go-to. There are many types of savings accounts - including fixed rate products, where you lock your money away for a set period of time, usually a number of years; and then there are more easy-access options. 

But while savings offer very low risk, they are also very low return. Bear in mind too that inflation can chip away at the real value of cash in an investor’s pocket and even with the current savings rates on offer from banks, they are still unlikely to provide inflation-beating income.

When it comes to investing, future returns are not guaranteed, but the long-term expected returns are greater than the expected return from cash savings. Investing should be a long-term endeavour – at least five years, if not much longer; as the longer you can hold your investments, the greater the potential for returns.

Below we briefly outline the main sources of income and highlight the potential risks and rewards

Bond investing

Investing in bonds means you are lending your money to a government or corporation for a fixed period, in return for a regular income. Bonds, sometimes referred to as fixed income, are essentially ‘IOUs’ issued by corporations and governments looking to raise money - and in exchange, investors receive a fixed rate of interest known as the ‘coupon’. When the bond’s term reaches maturity, the original investment, or principal is paid back to the bondholder.

Over the lifetime of a fixed maturity bond, the total return to the investor is determined by coupon payments. As such, bonds play a very important role in portfolios seeking to be focussed on income generation.

Interest rates are closely related to bond prices. If investors think rates will rise, then bond prices typically fall in value as new bonds coming to the market will offer higher coupons, reflecting the higher interest rate. Equally if interest rates fall the reverse is true – a bond’s value will rise, but its yield will drop.

There are many types of bonds with different characteristics, each with their own risk/reward profile. Independent bond ratings agencies such as S&P and Moody’s assign credit ratings to companies and governments based on their financial strength, i.e. their ability to repay their debt. The most common types of bonds include:

• Government or sovereign bonds: Debt issued by governments - such as US Treasuries, or UK gilts - are considered low risk, as they are backed by the state, but returns are also typically quite conservative.
• Corporate bonds: Debt issued by a company, which wants to raise money to fund its business activities or special projects. Generally seen as riskier than government bonds, corporate bonds tend to have a higher coupon payment to compensate for the additional risk.
• Inflation-linked bonds: These are tied to different measures of inflation such as the Consumer Price Index, and both the principal of the bond and its coupon are adjusted for inflation. This can help offset the impact of higher inflation as a way of protecting the bond’s value over the lifetime of the bond
• High-yield bonds: High yield bonds are at the riskiest end of the fixed income spectrum and are generally issued by companies which could be more capital-intensive and could have higher levels of debt – and therefore could be seen as a higher credit risk. They can offer investors the potential for much higher rates of income, to potentially offset the higher risk of principal loss. 

Dividend-paying stocks

Investing in shares is riskier but can potentially reap substantial rewards. Take the past five years, when there has been a global pandemic, war in Ukraine and a tricky economic backdrop that saw inflation and interest rates soar. Despite this, the Euro Stoxx 50 and S&P 500 indices have respectively risen by 40% and 85% over the period¹ ; a far higher return than any savings account could have delivered.

Many companies give a portion of their profits back to their shareholders in the form of dividends. They are usually paid in cash but can sometimes be paid by granting investors extra shares. Not all companies pay dividends, and instead reinvest the profits back into growing the company – typically, this means that more mature companies are among those more likely to pay dividends.

Shares represent partial ownership of a company. Therefore, shareholders have a claim on the cash-flow of that company and once creditors have been paid, including coupons to bond holders, remaining cashflow can either be paid to investors (shareholders) or re-invested in the company. For income-focussed investors, companies with high dividend payout ratios and low levels of debt are the most attractive.

Recently, some high profile and high-growth technology companies have announced their first ever dividend payments, including Google’s parent company Alphabet and Facebook owner Meta.

Dividend-paying shares are certainly worth considering. One analysis found that globally US$339.2bn was paid out in dividends in the first three months of 2024 - a record amount - and it is expected that a record $1.72trn will be paid in dividends for 2024 as a whole, a 3.9% rise on last year² .

Property

Investing in bricks and mortar can seem appealing but does come with its own risks, including house price depreciation, maintenance costs and the potential for long periods of vacancy or problem tenants if the property is being rented out. Property is also a particularly illiquid investment, as it can take a long time to sell if you want to take your money out.

But it is also possible to invest in a property fund, which means you can invest a smaller amount and your investment is spread across a portfolio of different properties

The benefit of compounding

Income investing needn’t solely be for income seekers though. Dividends from stocks, and the coupons earned from bond holdings, can also be reinvested to buy more shares, potentially helping build the overall value of your investments. By taking this route you could potentially enjoy the rewards of compounding, which Albert Einstein reputedly dubbed “the eighth wonder of the world”.

Essentially by reinvesting your income and returns you could supercharge your portfolio over the long term. It can help your money grow faster; it creates a snowball-like effect – if you are investing, or merely saving, compounding your returns will help your portfolio grow at a faster rate, as you are essentially earning interest on your interest.

Income investing can help provide a steady stream of returns, often with regular payments – though as with any type of investing, returns are not guaranteed. Diversifying across different asset classes – depending on each investor’s individual risk appetite - can help weather volatility in any one area. For many investors, it could make sense to take both a growth and an income approach – either through compounding or diversifying their portfolio to include stocks that are expected to perform well over time – in order to protect the value of returns and aim to achieve their financial goals.