Investing For Income
There are multiple ways to invest to provide your main source of income. My favorites are the stock market and real estate. Investing for income can provide a way to pay down debt, earn some extra cash, and support you in retirement.
This article will discuss investing for income in the stock market via stocks and bonds. In the stock market there are three forms of income; bond coupon payments, dividends and capital gains. Here are their formal definitions from Investopedia,
- Capital Gains – An increase in the value of a capital asset that gives it a higher worth than the purchase price.
- Dividend – a distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders. Dividends can be issued as cash payments, as shares of stock, or other property.
- Coupon – the annual interest rate paid on a bond, expressed as a percentage of the face value.
Put simply, capital gains are gains realized when a stock is sold for profit (at a higher price than its purchase price). For example, if I buy company X at $20.00 per share in December of 2015 and sell company X for $30.00 per share in December 2017 I have made $10 per share in capital gains. Conversely, capital losses occur when the share is sold at a price lower than the original purchase price.
When investing for income it is undesirable to focus on capital gains as the gains are only realized when the equity is sold. Therefore you only get paid when you are no longer an investor in the company and have nothing to show for this income, save paper gains, up to this point. Unfortunately, the grocery store and the bank won’t accept a screenshot of your paper gains as legal tender. So even though capital gains are a fantastic addition to other gains we should not focus on them as a primary revenue stream.
Dividends are far more reliable as a revenue stream. If dividend paying stocks are intelligently chosen these payments can provide a solid source of income which will feel like a paycheck periodically throughout the year. As most companies pay their dividends on a quarterly basis, we will assume all companies behave in this manner for the remainder of the discussion.
Dividends are your paycheck for owning the underlying company represented by that piece of paper we call a stock. These payments occur throughout the year and are readily available for the investor to pay bills, buy that nice cashmere sweater, or reinvest into more stocks and bonds. The dividend yield is the percentage of the price that is paid as a dividend. For example, if Company XYZ trades at $50.00 and has a dividend yield of 3.10% then $1.55 will be paid out per share at quarterly intervals. That is, there will be four payments of $0.3875 per share throughout the year.
A few of my rules when picking dividend paying stocks are,
- The stock has steadily increased its dividends over time and have had few periods where there was no dividend payments or no dividend growth (optimally, no such periods exist).
- Choose equities that need not take on additional debt in order to pay dividends to their shareholders. That is, the dividend payments can be covered by cash on hand and/or cash flow.
- Pick equities that have a dividend yield close to that of treasury notes. Because U.S. treasury notes are as close to risk-free as we can get it would be preferable to earn 2% from them with very little risk rather than 2% from a stock with risk of capital losses. However, a small amount of risk may be desirable as stocks can realize both dividend and capital gains. This risk threshold is dependent on the investor and their situation.
A coupon is very similar to a dividend. A major difference being the pay frequency. Bonds can make coupon payments on what schedule they prefer but typically the payments will be semi-annually. Like dividends, the typical semi-annual schedule will be assumed for any following examples.
Unlike stocks where the investor owns a portion of a company represented by the stock, bondholders hold a companies debt. Many companies need to raise more capital than the average bank is willing to loan, therefore they come to individual and institutional investors to raise their capital. Because bonds are liabilities the bondholders are entitled to repayment before the stockholders in event of bankruptcy. However, if we are investing for income we should avoid companies showing any signs of bankruptcy, although predicting the future is difficult.
Because the bond is a portion of a company’s debt the bondholder’s payments, the coupons, are the interest paid on the debt. Let’s take the following bond for sake of example:
- Par Value – $1000 (The par value is the face value of a bond. When a bond matures the borrower pays the lender the par value, typically $1000.)
- Coupon Rate – 3% (The interest rate on the bond.)
- Market Price – $997 (The price the market has assigned the bond. No matter what the market price the borrower owes the face or par value on maturity.)
- Years to Maturity – 5 Years (The bonds par value will be paid to the borrow in 5 years, assuming there is no bankruptcy).
Based on the above example, when the bond matures in 5 years the bondholder will receive an additional $3 in capital gains. But like a stock’s capital gains these are essentially useless when investing for income as they are only realizable when you are no longer an investor in the bond. The income from this bond will come from the annual coupon rate, here 3%. The annual payments on this bond can be found by taking the par value multiplied by the interest rate as a decimal, simply 1000*.03 = $30. Since we are assuming this is paid semi-annually that would mean you will receive $15 every six months from this bond. Over the course of 5 years this bond will make a total of $150 in coupon payments.
For the sake of this example, we’ll assume the bonds have no special contingencies and the company will not go bankrupt. Although coupons are the focus of this article, bonds can also experience capital gains when they are purchased under par value and paid in full by the borrower. The total yield on a bond is referred to as the Yield to Maturity, or YTM. This metric is perhaps more useful when screening bonds but only the coupon rate will be paid out to the investor periodically. A side note, when using an online broker, the broker’s commission fees are typically not included in the YTM calculation, be sure to include any of these fees in your calculations.
In conclusion, when investing for income it is advisable to buy stocks that have a history of dividend payments and a history of an increase in dividends on an annual basis. These stocks are likely to be large blue chip stocks which are leaders in their respective industries, if not, we should focus on purchasing only mega-cap industry leaders as they are less likely to fail and more likely to maintain the dividend payment. Moreover, it would be wise to have some amount of diversification among your dividend paying stocks as to trump capital losses, should they occur.
Because we are focused on earning income from these stocks they should be sold almost immediately in the event of the dividend being cancelled. Dividend decreases are less harmful since all companies hit speed bumps, but this action can be a sign of weakness. Many people get attached to their equities, especially after holding them for extended periods, but as disciplined income earning investors we need to check our emotions at the door.
Optimally, a mix between both stocks and bond is recommended. This will allow the investor dividend payments from the stock, coupons from the bonds, and potential capital gains from both assets. Even though we are not focused on capital gains, it certainly won’t hurt if you realize them to increase your net worth.