Everybody dreams of life of play while their investments keep the money rolling in. This, of course, can become a reality, and income investing is the strategy that will give you this “passive income”. But income investing is not as passive a strategy as you may believe. This article will look at various options including shares, rental property and fixed income instruments.
When looking to earn dividends it is important to remember that companies which consistently pay dividends are mostly found in the less cyclical sectors of the economy, such as consumer staples (food, alcohol, tobacco and apparel), pharmaceuticals and the insurance sector. These consistent dividend payments are a function of the quality in the earnings. Examples of shares with these traits include Nestlé, Johnson & Johnson, Siemens, Coca-Cola and Procter & Gamble, and locally Shoprite, Sanlam, FirstRand and Santam.
Mining and commodity companies tend to be more cyclical in nature and fall short of the definition of consistent dividend payers, since they have no control over the movement of commodity prices. Companies like Sasol and BHP Billiton had to abandon their progressive dividend policies during the cycle of low commodity prices in 2015 and converted to a dividend cover policy. Don’t underestimate the potential “surprise bonanza” on the upside when the commodity cycle turns in your favour.
Generating income in the property sector for your own account requires specific skills. Rental from direct property investments can be very rewarding and with rentals escalating, real estate values increasing, and a healthy demand by tenants, collecting your income through this avenue is a pleasure.
However, the property sector can be very challenging at times. Economic downturns, changes in trends, escalating costs and problems with tenants can turn the rental property investment thesis upside down. As a property investor recently remarked: “Stay close to your tenants and keep a personal hand on the property.”
The reward for more risky direct investments is a higher yield relative to listed property in the form of Real Estate Income Trusts (REITS). Income from listed property has greater revenue diversification, requires less direct involvement and spreads risk both geographically and between different sectors in the economy.
Fixed income securities and money market instruments offer extremely attractive interest rates from time to time, normally associated with periods of higher inflation, which puts the principle capital at risk of losing real value (with the exception of inflation-linked bonds). Combined with the income being taxable, fixed income can lose its attractiveness as a long-term investment when compared with growth assets such as shares and property.
Corporate bonds are another option and trade at a spread over and above that of an equivalent maturity government bond. The higher yield offered is to compensate investors for taking on additional credit risk. The lower the credit rating on a company’s debt, the higher the yield should be to compensate the investor for the risk of potential default.
IMPORTANT POINTS TO REMEMBER
The major consideration for an income-focused investment strategy is its ability to keep up with inflation. Ideally when managing these assets you want to create income streams that outperform inflation and generate economic growth. Success in these investments not only improves the outcome for income but increases the capital base from which income is derived.
Capital assets which keep track with inflation (or even better) provide the basis from which an income strategy can be implemented with a margin of comfort. Drawing on the income without having to sell shares or property (capital) is first prize.
Tax is key when planning an income strategy. For property it is the after-tax income on rental properties that matters. Tax on the yield is unavoidable, while adding professional management fees to the mix should also be considered. Be willing to pay for sound advice on something as important as securing your income. Proper tax planning when creating income producing assets could ensure you take advantage of the options available to reduce your tax bill.
NO INCOME IS TRULY PASSIVE
Whether an income strategy is designed for re-investment or funding your living expenses, both have their place in the investment universe. But do note, income investing takes skill, time and dedication – as a client reminded us: “There is no such thing as passive income.”
Written by Riaan Campbell, Citadel Advisory Partner