Income investing: A primer for your life stage

INCOME is a prized attribute of investments, particularly at a time when interest rates remain very low. Deposit rates currently are below 1 per cent a year; the latest issuance of the Singapore Savings Bond in January will return 1.64 per cent a year over 10 years.

In Singapore, income investing is evergreen particularly among those near or in retirement. Real estate investment trusts (Reits), for instance, are a staple. Funds that claim a high annual distribution rate are popular and so are retirement insurance products which provide a regular payout in retirement. Based on the latest available Life Insurance Association data for 2021 up to end-September, new business premiums in the segment rose 17 per cent to S$295 million.

But income investing has its challenges, particularly for those who do not wish to take too much risk. In a low-rate environment, too many investors chase too few quality assets with yield, which further depresses the yield.

Today's backdrop is particularly uncertain. Inflation has risen significantly in many countries, further spurring demand for an attractive yield. Interest rates are also expected to rise and this has fuelled volatility. Higher rates put pressure on stock valuations and cause bond prices to fall.

In response to customer demand Endowus has launched 3 multi-manager portfolios under the Endowus Income Portfolios series. But more on that in a while.

To start, there are a couple of things to note about income investing in general.

High yield

One, a high yield is enticing but is also associated with higher risk. For income investors, capital preservation is likely as important as income. This means they have to select high-quality and creditworthy assets and not invest blindly for yield alone. Among stocks and bonds, a spike in yield may reflect market conditions such as inflation jitters or a liquidity crisis. But in certain cases, all things being equal, an unusually high yield may signal distress.

In fixed income, there are segments with higher yield such as "junk" bonds with credit ratings below investment grade. These have a place in diversified portfolios.

Funds marketed with a high headline distribution rate, however, should raise some scepticism particularly if the rate is significantly higher than what markets can generate today. Funds are typically allowed to make distributions from two sources - current portfolio income and capital, which includes capital gains.

While most fund managers profess their aversion to making payouts out of capital, they may do so to fulfil a high promised payout rate. The question is whether payment out of capital is a regular and consistent practice, as it is a sign that the headline payout rate is unsustainable, and what you believe is income may actually be the return of your own money.

Morningstar looked into this issue in a recent study of 185 income-distributing funds in Hong Kong, each with assets under management of at least US$100 million. Among bond funds with at least 4 per cent annualised yield, three-quarters ended up with a lower net asset value than at the start of the review period.

Says Endowus chairman and chief investment officer Samuel Rhee: "There are many solutions in the market that allow for the principal to be used to fund a distribution. Hence investors will realise that they are decumulating or drawing down on their original invested principal amount and are technically using their own money to pay themselves on income.

"This is quite ironic and defeats the purpose of building an income portfolio. It is also not well understood in the market."

The second thing to consider is the tradeoff you need to be prepared to make, depending on your objectives. Is receiving a high current income your main priority? Or, do you desire growth for a long-term saving objective?

Total return

In this respect it is important to understand the distinction between income as a current objective and wealth accumulation for the long term. The line isn't a hard one. The concept of total return helps to illustrate the tradeoff.

Total return comprises three components - capital appreciation, income and gains from the reinvestment of income. Over the long run, income plus the additional gains from its reinvestment could account for a significant portion of total returns.

An income investor whose priority is to receive a current income for daily expenses, for example, is unlikely to reinvest the income, and hence his or her total return is reduced. But those whose priority is long-term wealth accumulation, say for a retirement objective, would typically not withdraw the fund distributions. The income remains in the portfolio and is typically reinvested in additional fund units for growth.

Distinct customer profiles

Endowus has structured its income portfolios to target distinct customer profiles and objectives (see graphic).

The respective profiles of the portfolios illustrate the tradeoffs. Investors in the Stable Income Porfolio would set their expectations of capital appreciation downwards. The portfolio is invested mainly in investment-grade fixed income. It is targeted at those nearing or in retirement, or those who require a regular passive stream of income from savings.

For the Higher Income and Future Income portfolios, note that the risk statistics are almost on par for metrics such as volatility and the 12-month rolling worst return.

In order to achieve a higher current income, the Higher Income Portfolio makes allocations into higher-yielding fixed income assets with higher credit risk and whose volatility may be similar to equities. This portfolio is targeted at working adults, including those in the "sandwich" generation who have higher spending needs, but also have the ability to stomach a higher risk threshold.

The Future Income Portfolio makes a greater allocation into equities for growth. Some of the underlying funds do pay dividends but some are focused on long-term capital appreciation only. This is targeted at younger savers in their 20s and 30s who would like some regular income, but aim for long-term growth.

In the selection of underlying managers and funds, careful attention is paid to the funds' history and how frequently they make distributions out of fund capital.

Rhee says: "Qualitatively, we seek to understand where the fund manager sits on the spectrum, from being very conservative (only paying gross or net income and not taking from capital at all, even from capital gain), to very aggressive (comfortable to pay from capital gain and even capital). We always prefer those that are on the more conservative end.

"We understand that in some extreme market environments, it is inevitable to pay from capital in order to keep the income stream. But in normal market environments, we prefer funds that rarely dip into the capital. Additionally, we compare the fund's current payout target with its coupon rate and current yield to assess whether the current payout target can be sustained mostly by the natural coupon received by the underlying assets."