Generating a reliable income stream in the current era of low interest rates is far from easy. With yields from traditional sources such as government bonds increasingly slender, investors either have to accept less income when investing new capital or consider riskier alternatives. In this environment investors need to take extra care when building an income portfolio of shares, funds or other investments. Here are some tips that might help:
1. Never invest in anything just because it has a high yield
Broadly speaking, the higher the yield the higher the risk, whether it is in bond, equity or property markets. Treat a high yield as a warning sign – there could be a significant risk of the income being cut and/or capital loss.
2. Look at valuations versus history
Timing can be a significant issue when it comes to generating income. As asset prices rise, income yields fall – and vice versa. Try and turn weaker periods to your advantage and buy up your income-producing assets when they are cheaper.
3. Build a broad portfolio
Diversification is especially important in income investing. Being heavily reliant on one company, sector or asset class means your portfolio, and your income stream, is vulnerable. Use a variety of assets, ideally ones uncorrelated to one another (i.e. tending not to move up and down in tandem). A number of lower risk diversification options including cash and gilts provide only a small level of income presently, but that does not mean they should be ignored.
4. Big isn’t always best
Large companies are often more resilient and well-resourced than smaller firms, which makes them an obvious choice for income seekers. However, they can still be vulnerable. BP’s Gulf of Mexico oil spill and Volkswagen’s diesel emissions scandal are just two examples showing size doesn’t equate to safety.
5. Check cash flow is reliable
One test of income reliability is to what extent the income paid by the asset is covered by physical cash flow. For example, if income paid is from capital, from raising debt, or from an accounting profit not backed up by actual cash, then the level of income paid could be unsustainable. This is particularly relevant for individual shareholdings, where this assessment is referred to as “dividend cover”. If cash flow is robust and higher than the dividends paid by the company, then the yield has a better chance of being sustainable.
6. Make sure management are committed
If you are investing in individual shares it is worth keeping up to date with the company’s latest report and accounts, and other announcements, to consider any statements the management make about the dividend. Companies vary in terms of their approach, some realising that a significant number of shareholders invest with dividends in mind.
Remember, though, that doggedly keeping up dividends in difficult periods could have an adverse impact on the business as if the cash could be better spent investing for the future. For fund investors it is worth understanding the approach the manager takes and whether income is the priority, or whether it is “total return” – income and capital growth. Yields on all funds are variable and not guaranteed.
7. Don’t overpay for security
Companies or assets that seem defensive may not be so in a downturn – especially if they are overpriced. For instance, certain high-quality, low-volatility shares exhibiting steady earnings have become popular among investors looking for predictable income; but these “bond proxies” could see their share prices struggle as and when interest rates rise.
8. Try to avoid dividend cuts
Investors in individual company shares fear cuts to a company’s dividend due to falling profits. The market often punishes such companies in terms of share price – but as mentioned above it is often better for a company to cut the dividend and rebase it at a more sustainable level in order to keep a suitable amount of cash in the business. Companies that grow their dividends are usually rewarded with a rising share price so companies with smaller but rising dividends may make better long term investments than today’s biggest yielders.
9. Invest for the long term
Overtrading can eat into your returns. Not only does it interrupt the flow of income but it can incur transaction costs. The objective of patiently accumulating income from carefully chosen assets also assists you in taking a longer term view than many investors, which can be a helpful discipline.
10. Know your asset
Above all invest in what you understand and are comfortable with. This way you will be better equipped to assess risk. If an investment keeps you awake at night it probably isn’t for you.
This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in collectives should only be made after reading the Key Investor Information Document, Supplemental Information Document and/or Prospectus. If you are unsure of the suitability of your investment please seek professional advice.