Investing for an Income in 2024

Bonds

The first income investing vehicle we will look at are bonds.

Bonds are a fixed income investment which are issued by both governments and companies looking to raise capital. The bond purchaser essentially loans this capital to the issuing entity at a fixed rate of interest. The loan is then repaid to the purchaser in full at the bond’s maturity.

Bonds are an integral part of any income investing portfolio and are generally considered to be a lower risk investment than stocks. However, this is not to say that they are without risk. Bond defaults can, and do, happen. 

Therefore, before purchasing a bond, it is important to do your research on both the issuing entity and the type of bond in question. Here are some specific things for you to consider when investing for an income using bonds.

Government Bonds – Lower Risk?

Generally speaking, government bonds are seen as lower risk for income investors, because governments are less likely to default on debt than a company. However, this is not to say that it does not happen. 

It is not unheard of for less developed countries to default on their sovereign debt in times of economic hardship. As a consequence, countries which are known to be serial defaulters tend to offer higher yielding bonds – but it is important to remember that with this higher return comes considerably higher risk.

Bond Duration – Long-term or Short-term?

Another important factor to consider when investing for income is the duration of the bond, which can range from anywhere from six months to a hundred years!

It may be tempting from an income investing perspective to lock yourself into a bond with a long duration and simply collect the annual interest payments until maturity, but you should be wary of doing so.

As we have witnessed over the last year or so, interest rates are subject to change depending on monetary policy objectives. A bond yield which looks attractive today may not appear so attractive in several years’ time.

Moreover, bonds are tradable on the secondary market and their value is inversely related with interest rates. In other words, when interest rates rise bonds lose value, conversely when interest rates are cut, bonds rise in value. 

It is important to note, however, that if you intend to hold a bond to maturity, its secondary market value will not have any impact on your bond's interest rate or repayment amount at the end of the term. Its secondary market value will only be relevant if you decide to sell the bond to a third party before it matures.

Dividend Stocks

Many public companies choose to regularly distribute a portion of the company’s earnings in cash among its shareholders. These payments are called dividends and dividend stocks are the next method of investing for an income which we are going to look at.

Possibly the most attractive element of investing for income using dividend stocks is that it allows the investor to pursue two sources of potential gains: the income generated from dividends and the potential appreciation of the stock’s value over time.

However, there are some circumstances where a company may not be able to maintain their dividend payments due to the economic climate and have to suspend them for a period of time. The Covid-19 pandemic was a prime example of this, with many companies forced to preserve capital and temporarily suspend dividend payments to shareholders.

Before investing in any company, it is important to conduct an assessment of its fundamentals. If you are strictly looking at dividend stocks for an income investment, there are a few metrics which are important to consider.

Dividend Yield

The dividend yield shows a company’s annual dividend payment as a percentage of the current share price. For example, if a company distributed £1 per share and the current share price was £20, then the dividend yield would equal 5%.

The dividend yield is probably the most well-known metric and one of the most useful when evaluating the merits of an income stock. Generally speaking, a higher dividend yield is preferred, but anything too high may not be sustainable over the longer term.

Depicted: Five highest yielding dividend stocks on the FTSE 100. Date Captured: 29 June 2023.

The Dividend Payout Ratio

The dividend payout ratio is the dividend payment expressed as a percentage of the company’s earnings. So, for example, if a company earns £1 per share and distributes a dividend of £0.25 per share, the payout ratio would be 25%.

Human instinct may make you think that the higher the payout ratio the better, but this is not necessarily the case.

At the end of the day, income investing is all about creating a reliable stream of income from investment and, in reality, the higher the dividend payout ratio, the less sustainable the dividend payments will be over the long-term.

Generally speaking, you would be looking for a dividend payout ratio of less than 50% - with the remainder being invested back into the company itself for future growth.

Earnings per Share

Earnings per share (EPS) expresses how much a company has earned for each individual share of its stock and is calculated by dividing total earnings by the number of common shares it has outstanding. This is an important metric to consider when investing for an income with dividend stocks.

Ideally you want a company whose EPS has a track record of increasing over time, as this should translate into the dividend also increasing over time. 

Not only from an income investing perspective, but a steadily increasing EPS also demonstrates the company is flourishing in their field.

Payout Growth

A dividend stock’s payout growth can be calculated by looking at the most recent dividend payment and comparing it with historic dividend payments.

An income investor will be looking for companies which have a demonstrable track record of increasing its dividend payments over time.

ETFs and Mutual Funds

Instead of purchasing individual income investments through dividend stocks and bonds, income investors may choose to invest in Exchange-Traded Funds (ETFs) or mutual funds instead.

Both of these types of funds pool investor money in order to acquire a basket of securities - allowing investors to gain exposure to a variety of investments in one. 

Investors can choose funds which only hold equities, bonds or a mixture of both. Moreover, there are numerous ETFs and mutual funds which specifically target income investments. These funds will target bonds, dividend stocks and other investments for income and distribute the cash generated to their investors.

In the following sections, we will take a quick look at two examples of ETFs which could be used by investors looking to invest for income. The first focuses on equities, whilst the second instead focuses only on bonds.

SPDR S&P UK Dividend Aristocrats UCITS ETF

The SPDR S&P UK Dividend Aristocrats UCITS ETF (UKDV) is an example of an ETF which might be suitable for those looking to invest for income.

The UKDV ETF passively tracks the S&P UK Dividend Aristocrats Index - which is an index made up of the highest dividend yielding companies in the UK.

In order to track this index, the UKDV ETF will hold shares in all the constituent companies and income earned from dividend payments are redistributed twice a year to the ETF shareholders. At the time of writing, the distribution yield for this ETF is 4.67%.

iShares USD Corp Bond UCITS ETF

The iShares USD Corp Bond UCITS ETF (LQDE) tracks an index which is composed of US dollar denominated investment grade corporate bonds. At the time of writing, the distribution yield of the ETF is 4.24%.