Investing for Income

You may hear that income investing is easier or less risky than growth investing. Don’t believe it. Investing one’s money so as to produce a good, steady income, year after year, is a real challenge.

Like growth investors, income investors need to protect their capital by diversifying. As an income investor, however, you also need to redefine safety and risk.

• Safety is a good dependable flow of spending money—income you can rely upon year after year.
• Risk is the danger that your flow of income will dry up or decline precipitously. The greater the uncertainty about how much income an investment will generate in some future year, the greater your risk.

Growth investors generally consider stocks to be riskier than bonds and bonds to be riskier than “cash equivalents,” such as Treasury bills or six-month CDs.

For income investors, the risk rankings are reversed. The income comparisons in this article show why. Each bar graph records the income that would have been produced by a hypothetical investment of $100 made at the beginning of 1970 and maintained until the end of 1999.

Treasury bills. Growth investors consider T-bills to be “risk free.” But look at the feast-or-famine fluctuations in annual income. For long-term income investors, T-bills and other cash equivalents, such as money market funds, look more like a high-risk gamble.

Bonds. Bonds are a good source of steady income, but only until the bonds mature. The graph assumes that $100 is invested in a five-year bond. Each five years the bond matures, and the proceeds are reinvested—and the income level changes, depending on whether interest rates have risen or fallen. In real life, fortunately, income investors don’t have to limit themselves to one maturity. For instance, you might divide your money among issues maturing in three, five and seven years. With staggered bond maturities, the cliffs shown in the bar graph would turn into gentler slopes.

Stocks. Whether you buy stocks for growth or for income, diversification is a must. (If you own only one stock and the company in which you are a shareholder goes out of business, you would lose both your investment and your quarterly dividends!) With adequate diversification, stocks become a remarkably dependable income source. The flow of dividends from the S&P 500 has grown quite steadily through the three decades. This growth has helped many income investors maintain their purchasing power despite inflation.

The drawback to stocks as income investments, especially after the record market highs of recent years, is low immediate yield. The dividend yield on the S&P since the
beginning of 1998 has remained below 2%.

The added advantage offered by stocks is the potential for long-term growth of capital as well as income. By the beginning of 2001, an investor who had put $100 into an “average” portfolio of stocks back at the beginning of 1971 would have seen the market value of the investment grow to more than $1,400. And that was without reinvesting dividends.

Inflation-proof Treasury bonds

Inflation is one thing that income investors won’t have to worry about with a new type of bonds from the U.S. Treasury. They’ll have other worries, though.

Each quarter since 1997, the Treasury has released an inflation-indexed ten-year Tnote. They also issued a five-year note in July 1997 and a 30-year bond in April 1998.

The bonds pay a fixed rate of interest determined at auction, but the face value is adjusted for inflation as measured by the Consumer Price Index. Thus, investors will see their semiannual interest payments rise along with the CPI. What’s more, they’ll receive the higher, inflation-adjusted principal value when their bonds mature.

The bonds may be bought at issue directly from the Treasury or from broker-dealers in the secondary market.

The new worries:

1. The rate of interest paid on the inflation-adjusted bonds is lower than the rates offered by conventional Treasury bonds. Investors must decide whether they’re willing to accept initially lower income in return for inflation protection.

2. Each year investors will be required to pay income tax on both the adjusted interest payments and the inflation adjustment to the principal value of the bonds. That means they’ll be paying annual income tax on dollars they won’t receive until they sell or redeem their bonds. For this reason the inflation-indexed bonds appear best suited to IRAs and other tax-deferred accounts.