DIY Investor Magazine
/
December 2015
14
Generating an income has been an increasingly
important objective for many investors. The income
available from conventional savings accounts has
dwindled to near-zero at a time when changes to
the pension rules have set more retirees in search of
income-generative investments to replace an annuity
income stream.
Plenty of investments advertise a high income, or a
growing income, but what do investors need to bear in
mind in the selection of income investments?
Investment income tends to come from two main
sources: dividends from shares and interest payments
from bonds.
Each type of income has different characteristics –
dividends from shares tend to be better at mitigating
the erosive effects of inflation but share prices can be
volatile and subject to large price movements.
Bonds are effectively loans to a company or
government which are issued with a promise to pay
the money back at a fixed time along with interest at a
fixed rate. They are often considered to be at the lower
end of the risk spectrum but the potential for returns is
usually considered to be lower too. Interest payments
from bonds, also known as coupons, have historically
proved more consistent than dividends from shares.
As such, holding a blend of income sources in a
portfolio can offer greater consistency over time.
James Crossley,
Retail Distribution Director
Jupiter Asset Management Securities
From there, it is tempting simply to pick the highest
income available, but this approach can have a number
of limitations. First and foremost, a high yield may be a
sign of distress.
At a time when interest rates are at 0.5%* and the
income available on cash savings is negligible, an
investment paying 7-8% is likely to be taking a lot
of risk to achieve that income. It may be invested in
companies that are having problems, where there is
an expectation that the dividend will be cut, or there
might be a default on the bonds. Investors may want to
consider how an income is being generated.
Equally, the income may be artificial – in other words,
it may have been increased using complex financial
instruments, such as derivatives whose values are
derived from another underlying asset e.g. shares.
Fund managers can use complex instruments to raise
the income level of the fund when the assets fail to
produce it naturally through dividends and coupons.
This is a valid strategy, but can mean higher risk and
come at the cost of sacrificing some of the potential
returns when the assets are doing well. For investors
who want to preserve the purchasing power of their
long-term savings – to pay care home fees, for example
or leave a legacy to their family - this may be an issue.
As such, for most investors an investment generating a
natural yield, rather than artificial one, from a blended
portfolio might be more appropriate. The yield (also
known as income) should be high enough to mitigate
inflation and, ideally, should also exhibit some growth.
GENERATING AN INCOME
FROM INVESTMENTS
INVESTMENT INCOME TENDS TO COME FROM TWO
MAIN SOURCES: DIVIDENDS FROM SHARES AND
INTEREST PAYMENTS FROM BONDS
