What is income?

When investment professionals talk about income they could be referring to several slightly different concepts. But the most common (and useful) definition is the natural income.  

Natural income is the cashflow generated by a set of assets. In the fund investment world this is the cash produced by securities in a portfolio, whether that’s dividends from equities, coupons from bonds, rental income from real estate, or net cashflow from infrastructure projects.  

Importantly, natural income does not include cash generated from selling assets i.e from liquidating the underlying capital. If assets in a portfolio are a factory, then income can be thought of as the factory’s output. If you dismantle the factory, then output falls. In the same way, liquidating assets may create a one-off gain, but future income is diminished.   

What is yield? 

Yield is a measure of return. Again, there are different definitions, but the current yield (sometimes called the running yield) is particularly helpful from the perspective of income investing. 

Current yield is the percentage measure of income as a proportion of the price of an asset. Because it is based on the current price, as opposed to the face value, it can differ from income measures such as the coupon rate of a bond. The current yield comes into its own as an easy way to compare investments; it’s a quick frame of reference for income today.  

When analysing ‘real’ assets such as real estate and infrastructure, costs and fees of managing the asset can vary from project to project and have a significant effect on yield, so they should not be ignored. For financial instruments such as equities and bonds, costs tend to be small and comparable.

Formulas for yield calculations

.

Source: Fidelity International, June 2019

What is the distribution an investor receives from an income fund?

An investor in the distribution share classes of an income fund receives a regular payment. This payment comes from either the income generated by a fund’s assets, the realised gains on those assets, the actual capital of the assets, or a combination of them. The distribution can also be pre-specified, so investors know beforehand what they’re getting, or it can vary depending on the performance of the underlying assets. It is important is that investors know what the distribution is based on because different approaches have benefits and drawbacks.

For example, if a fund makes distributions from its capital base, it reduces the potential for future income generation because it has fewer assets but it can make higher payouts in the meantime. Using realised gains for distributions gives up the opportunity to reinvest and build assets for the future in favour of a short-term windfall.

A specified distribution helps investors know what to expect so they can better manage their budget. The problem comes when fund assets underperform, and, in order to deliver the promised distribution, a manager has to sell assets. If markets go through a period of prolonged weakness, this could lead to a downward spiral where there are fewer assets to generate the required distribution. More assets therefore must be sold to make up the shortfall and so on, until the capital base of the fund has shrunk so much it may never recover. 

For investors who depend on income to finance their retirement, or for institutions servicing their liabilities, a specified distribution can pose risks. Similarly, a variable distribution based on a yield on assets introduces other considerations for investors because the payout can differ from period to period as the values of the underlying securities fluctuate. 

What types of distribution methods are there?

Within the confines of fixed or variable distribution different methods can be applied. For instance, funds can choose to pay out only natural income net or gross of fees. A net basis subtracts fund fees from the natural income while a gross basis pays out all the income and subtracts fees from the capital. Both approaches are generally sustainable with the gross method able to absorb fees through capital appreciation.

Funds can also specify an absolute number for the distribution or a percentage of NAV (net asset value). An absolute figure offers investors certainty, but the fund manager has potentially less flexibility in managing the fund. On the other hand, a percentage specification can lead to a fluctuating income for the investor but more freedom for the manager. Additional flexibility for fund managers comes from discretionary distributions where the manager pays out income within a specified range; the manager can choose to distribute a higher or lower amount as long as it’s within the band.

Whether the fund pays income on an absolute or percentage basis, if the natural income level falls short, the fund will have to dip into the capital to make up the shortfall.

How can investors maximise income distribution?

Maximising the distribution may not be the best way to think about income investing. Instead, it’s important to be aware of the risks of different solutions which increase or decrease the distribution. Investors who require a higher income, can gravitate towards funds which allocate a part of the capital to the distribution, while investors who can manage with a lower income can choose funds which put more emphasis on capital preservation.

Funds with a higher distribution may offer a target distribution above their natural income. In those cases, the manager liquidates some assets to cover the difference. However, over time this will reduce the capital base of the fund, so this solution tends to work well for investors with a shorter time horizon. For investors with a longer time horizon, a fund which balances income-generating investments with capital preservation and growth can provide a smaller but longer lasting income stream.

For example, chart 1 compares the actual results of investing £10,000 in each of six Asia-focussed income funds from a selection of fund managers measured over nearly three years. Fund A has a conservative approach to income, paying out an amount slightly lower but comparable to most of the other funds. However, the capital preservation tilt of the fund means that its total gain with (£3,382) or without (£2,351 = £908 + £1,443) reinvesting income is substantially larger than the other funds. Fund F, which takes the most aggressive approach, pays out the highest amount of income but has seen its capital base fall the most.

Source: Morningstar Direct, 31 May 2019

With income investing, it can be useful to think about optimising distribution rather than maximising it, and investors have to pick the distribution that best suits their needs. A conservative distribution target leaves more room for building capital, while an aggressive distribution pays out more income but is less protective of the capital base. 

What should income investors consider when choosing an income portfolio?

An income portfolio contains three key levers: income, capital and yield. It’s very difficult to control all three but it makes sense to prioritise income and capital, of which yield is a function. Investments with good income generating capability and broad capital stability should form the basis of an income portfolio. 

The three levers of an income portfolio

.

Source: Fidelity International, June 2019

Before populating a robust income portfolio an investor must first decide on the level of risk they find acceptable. More risk generally means higher income but at the cost of reliability, and lower risk sacrifices some income for more reliability. Rather than being on the extremes, a good balance can be found by some combination of income that is attractive yet stable. And, of course, an investor’s individual circumstances play a big role in their risk appetite.

The next step is to consider the global opportunity set. Income securities exist across the world and by spreading investments regionally, and across asset classes, capital structures and sectors, the exposure to idiosyncratic risk is minimised. In addition, diversifying by types of income can inject extra resilience in to a portfolio. In practice, that means holding a mix of floating and fixed rate, high and low growth, short and long duration, and liquid and illiquid income securities. 

Finally, investing defensively protects the asset base: setting aside a liquid sub-group of assets to sell in times of stress to either shore up the portfolio or redeploy cash when better opportunities arise elsewhere. 

Are there any other ways to boost income?

There are two broad ways to enhance the income level of a fund: biasing investments towards higher yielding securities or derivative overlays. Picking higher yielding securities usually comes with more risk, such as high yield bonds versus investment grade. 

Derivative overlays generally reduce risk by selling uncertain capital upside for a certain premium. For example, dividend funds often sell call options on the stocks they own, giving up some potential capital gain in exchange for extra income. But more exotic solutions can introduce complications. So-called ‘double-deckers’, which have been popular with some retail investors in Japan and elsewhere, invest in fixed underlying assets, and then swap the income flows into a currency with higher interest rates in order to pay higher returns. This strategy can lead to capital losses if the currency market turns. An example happened last year when European high yield bond funds in Turkish Lira wrappers fell sharply amid the Turkish economic crisis

How do different approaches to income investing respond to changing markets?

The last decade has been unusual because we’ve only seen one set of market conditions: an enduring bull market in both bonds and equities. This won’t last forever. Eventually the cycle will turn and we will go through a bear market. How income funds perform in such a time will depend on how the portfolio is constructed.

Portfolios designed to maximise income generation and distributions, often by taking high levels of risk and/or concentrating security selection, could be susceptible to capital losses in a market downturn. Funds with a more balanced profile and robust characteristics, taking moderate risk and diversifying assets, may ultimately deliver the better long-term outcomes for income investors despite currently trailing their risk-embracing peers. 

For example, the final quarter of 2018 saw equity markets sharply sell off, which indicates how income funds could react in a bear market. Chart 2 compares the performance of two income funds with the index and peer group during this period and subsequently. It shows that Fund A, which is conservatively managed, lost the least value in Q4 2018, while making the highest returns so far this year, more than recovering the lost value during Q4. Fund A weathered the volatility better than the market index and the average open-ended global fund. The more aggressive income Fund B lost more value than Fund A, the index and peers, and is still a long way from recovering the lost capital.

Source: Morningstar Direct, 31 May 2019

What are the main risks associated with income investing?

Higher yielding assets tend to have more risk. Indeed, high yield issuers offer greater returns to entice investors willing to risk their capital. For income funds, the same rule applies, where higher distributing funds tend to take more risk with investors’ capital. 

Distributions from income funds also face the eroding effects of inflation. Unless natural income and consequently fund distributions are exposed to some growth, the real value will fall over time. To counter inflation, income investors can seek funds that are balanced between income and growth. Inflation-resistant portfolios can include inflation-linked bonds, equities, real estate and infrastructure assets which all tend to increase cash flows at or above inflation. Within asset classes, some securities will do a better job of growing income than others. For example, ‘bond proxy’ stocks with high dividend payout ratios tend not to be the best inflation protectors because they have limited room for dividend growth.

Income investors should also be watchful of bond defaults and reinvestment risk. Defaults result in a permanent loss of capital, hurting long-term income generation. Fund managers who are selective offer investors the discretionary judgement to sidestep these pitfalls while still exploiting the best opportunities.

Finally, investors should be wary of much of the advertising of income funds. The level of income offered by a fund is not a measure of return. Some investors, perhaps not adequately warned, conflate the periodic distribution of an income fund with its all-round performance. It’s easy to be lulled into thinking a fund which posts its specified distribution without fail as a success, but distributions in the short-term are only one aspect of performance. They say nothing about capital preservation, which, if ignored, could eventually lead to faltering distributions, and leave investors unprepared and worse off. 

Are there any principles to apply in income investing?

We can briefly summarise the main lessons of income investing with a few important principles:

• Income portfolios, like most investment strategies, will benefit from broad diversification across asset classes, geographies, sectors and types of income.
• When choosing an income fund it is paramount to understand the basis of distributions. What is the fund’s target distribution and how is it paid? Is this level of distribution sustainable?
• Do not confuse regularly delivered distributions with overall fund performance. The underlying capital base is the engine which drives income generation and ignoring it could mean failing to meet long term investment outcomes.
• A good balance between capital stability and income growth will help preserve and grow capital while increasing real income.