What Is Income Investing?

Income investing is an investment strategy focused on generating regular cash returns from a portfolio of assets, rather than primarily seeking capital growth. The income typically comes from dividends paid by companies, interest on bonds and distributions from funds. Together, these create a steady cash flow that can supplement other income or be reinvested for further growth. 

This article covers how income investing works, how it compares to growth investing, the key metrics used to evaluate income investments and the main risks involved.

The information in this article is provided for educational purposes only and does not constitute financial advice. Consult a financial advisor before making investment decisions.

Types of Income Investments

Income-generating assets fall into several categories, some of the most common include: 

• Bonds 
• Dividend stocks 
• Income funds and ETFs 
• Real estate investment trusts (REITs)

Bonds

Bonds are debt instruments issued by governments and companies to raise capital.  

When you purchase a bond, you are effectively lending money to the issuing entity in return for regular interest payments, known as coupons, over a fixed period. At the end of that period, when the bond matures, the principal is returned in full. 

Whilst bonds are typically considered to be lower risk than stocks, the exact level of risk depends on the issuing entity. Bonds which are deemed to be higher risk tend to offer higher yields than those which are considered lower risk. 

Bond prices have an inverse relationship to interest rates; when rates rise, existing bond prices fall, and vice versa. This matters most to investors who might consider selling bonds before they mature.

Another important factor to consider is that bonds come with different durations. A long-dated bond locks in a yield over a longer period, which might look attractive when rates are high, but becomes less so if rates rise further. Furthermore, the longer-dated the bond, the more vulnerable it is to inflation. 

Dividend Stocks

Many publicly listed companies distribute a portion of their profits to shareholders in the form of dividends. These dividend stocks provide investors with income as well the potential for share price appreciation over time. 

Unlike bonds, which tend to offer fixed payments with limited upside potential for capital growth, dividend stocks can deliver both income and long-term growth, although neither is guaranteed. 

Companies with a long track record of paying and growing their dividends tend to be more established, cash-generative businesses, with utilities and consumer staples being typical examples.  

Income Funds and ETFs

Rather than building a portfolio of individual bonds and/or stocks, many income investors use mutual funds and Exchange-Traded Funds (ETFs) to gain diversified exposure to a variety of income-generating assets through a single investment. 

• Equity Income Funds: Hold portfolios of dividend-paying stocks. 
• Bond Funds: Create portfolios of government bonds, corporate bonds or a mixture of both. 
• Multi-Asset Income Funds: Can hold a combination of equities, bonds and even other asset classes. 

When investing in a fund or ETF, it is worth checking whether units are designated as income/distributing or accumulation. Income units distribute cash payments to investors at regular intervals, whereas accumulation units reinvest any income back into the fund. 

Real Estate Investment Trusts (REITs)

Real Estate Investment Trusts, or REITS, are companies that own and operate income-generating properties, providing investors with exposure to this type of real estate without directly owning it. 

REITs are listed on stock exchanges and trade like ordinary shares, providing a level of liquidity that direct property ownership does not. 

A defining characteristic of REITs is that they are required to distribute a minimum of 90% of their taxable income to shareholders in the form of a dividend. This inherently makes them income-oriented, and their yields can consequently be relatively high compared to other income investments.  

However, it also means they cannot rely on profits to fund future growth. Instead, in order to fund new projects or acquisitions, they typically need to borrow money, which results in many REITs having a high level of debt. This can make them particularly sensitive to changes in interest rates. 

Key Metrics for Income Investors

• Dividend Yield: The annual dividend expressed as a percentage of the current share price. A yield which is too high can be a red flag, as it may signal an unsustainable dividend or a declining share price. 
• Dividend Payout Ratio: The dividend expressed as a percentage of earnings. Lower ratios generally indicate a more sustainable dividend, whereas a high ratio may indicate the opposite. 
• Dividend Growth: A track record of increasing payments over time. For longer-term investors, consistent dividend growth can be as important as the current yield. 
• Yield to Maturity: The total return from holding a bond to its maturity date, accounting for coupons and any difference between the purchase price and face value. This is generally considered one of the most useful metrics for comparing bonds with different maturities and different yields. 
• Credit Rating: An assessment of an issuer's default risk made by an external credit rating agency. Investment grade bonds carry lower risk and lower yields, whilst so-called “junk bonds” offer higher yields to compensate for higher risk. 

Income Investing vs Growth Investing 

These two approaches represent different investment priorities. 

Growth investing targets capital appreciation by looking for assets that are expected to outperform the wider market over time.  

Companies favoured by growth investors also tend to prioritise growth themselves, with profits often reinvested back into the business rather than being distributing to shareholders as dividends. Consequently, potential returns tend to be largely unrealised until the investor chooses to sell. 

On the other hand, income investors prioritise generating regular income from their portfolio. Of course, the assets they hold may also appreciate over time, but that is not typically the main objective. 

In terms of stocks, companies that pay consistent dividends tend to be well-established businesses, which have more predictable cash flows but are typically slower growing.

Risks of Income Investing  

• Interest Rate Sensitivity: Rising interest rates cause existing bond prices to fall; higher rates can also weigh on dividend stocks and REITs. 
• Dividend Cuts: Companies can cut or suspend dividend payments when conditions deteriorate. 
• Inflation: Fixed income securities are particularly vulnerable to inflation. If inflation is higher than the interest paid by a bond, the real value of that income declines over time.
• Default Risk: Bond issuers can default on their obligations; credit ratings can help assess the level of risk. 
• Slow Growth: Prioritising income can mean accepting slower capital growth.  

How to Start Investing for Income

There are several ways of gaining exposure to income-generating assets. Amongst other things, the right approach depends on an individual’s objectives and how actively they want to manage their portfolio. 

Whilst direct investment in dividend stocks and bonds gives the investor full control over their investments it requires more research and active management. Furthermore, building a diversified portfolio of income generating assets may require a significant amount of capital. 

Income funds and ETFs offer a more accessible entry point. A single fund or ETF can provide exposure to a diversified portfolio of dividend stocks, bonds or a combination of both. This can be a practical option for those starting out or those who prefer not to manage individual holdings. 

Regardless of which option you choose, the process of getting started will be fairly similar: 

1. Define your income objective. Decide whether the goal is income now or income in the future.  
2. Establish your risk tolerance. Consider how much short-term volatility is acceptable in pursuit of income, and how reliant you are on the income the portfolio generates.  
3. Choose your investment route. Decide whether to invest in individual stocks and bonds directly or income funds and ETFs for diversified exposure. 
4. Open an investment account. An investing account is required to purchase income-generating assets. Make sure the broker you choose offers access to the markets and instruments you're interested in. 
5. Review periodically. Once you’ve made your investments, review your holdings regularly to make sure your portfolio continues to meet its objectives. 

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