If your primary investment objective is generating income for current use, bonds are likely the first asset class that comes to mind. You might also be familiar with common stocks that pay comparatively high dividends, such as utilities. But like all investments, stocks and bonds have certain advantages and disadvantages. They’re subject to particular risks at particular times under particular conditions. So it makes sense to explore other income-generating vehicles that can limit your risk through diversification, while providing distinctive benefits of their own.
HYBRIDS
The first category to consider consists of hybrids. These securities have characteristics of both stocks and bonds, with the result that their prices don’t move in lockstep with the prices of either of those classes.
Preferred Stocks
One type of hybrid is a preferred stock. Like a common stock, it pays a dividend, rather than interest, as a bond does. But typically, the yield you get on a preferred stock is substantially higher than the yield on the company’s common stock. The higher yield compensates you for the fact that unlike a common stock dividend, a preferred stock dividend doesn’t have the potential to increase over time as the company’s earnings grow. The preferred dividend, like a bond coupon, is either set at a fixed rate or readjusted periodically in conjunction with a specified market- based interest rate.
This contractual commitment makes a preferred stock dividend a more reliable source of income than a common stock dividend, which the board of directors can decide to reduce or eliminate altogether if the company’s earnings start to falter. The board can choose to suspend payments of preferred dividends, but is ordinarily highly reluctant to do so, as it sends a very negative message to the market about the company’s financial condition. In addition, the board is barred from authorizing dividends to common shareholders until the preferred dividend is reinstated.
Furthermore, some preferred dividends are cumulative, meaning that when the dividend is reinstated, the company must pay holders all the arrearages, that is, the dividends that were not paid during the suspension. Another advantage of investing in preferred stocks is that in many cases their dividends are qualified, meaning that you don’t pay federal taxes on them at the ordinary income rate. Instead, you pay a substantially lower tax rate, currently 15 percent or 20 percent, depending on your tax bracket.
Convertibles
Convertibles are a second type of income-producing hybrid. The category includes both convertible bonds and convertible preferreds. These securities combine a fixed-rate bond coupon or preferred dividend with essentially a call option on the company’s common stock. You consequently capture some of the stock’s upside while getting the downside protection that a contractual interest or dividend payment tends to provide. You can buy individual convertible issues or invest in them through open-end or close-end mutual funds or through exchange-traded funds (ETFs).
SHORT-TERM INCOME VEHICLES
Money Market Funds
A money market fund enables you to invest in a diversified portfolio of short-term, high-credit-quality debt instruments including Treasury bills, bank certificates of deposit, commercial paper, bankers’ acceptances, and repurchase agreements. Money market funds are insured by the Federal Deposit Insurance Company (FDIC). They can be used to park cash temporarily, while generating some income, in expectation of higher yields becoming available on longer-maturity instruments. But in some periods, high short-term interest rates make them attractive as a low- risk component of an income portfolio.
Certificates of Deposit
A certificate of deposit (CD) is an alternative to a savings account that offers a higher interest rate in exchange for locking up your cash for a period of several months to several years. You’ll typically incur a penalty for withdrawing funds prior to the CD’s maturity date. As long as the issuing bank is a member of the FDIC, a CD is insured for up to $250,000, subject to certain rules. Consult your bank or savings institution for details on insurance coverage.
PACKAGED PRODUCTS enable you to invest in a diversified portfolio, rather than incurring the risk inherent in owning a small enough number of individual securities
that you can feasibly monitor.
Closed-End Funds
Unlike an open-end mutual fund, a closed-end fund (CEF) trades at a market- determined price instead of always being purchased and redeemed at its net asset value (NAV) per share. Accordingly, a CEF may trade at a premium or discount to NAV. A discount doesn’t automatically make a CEF a good investment, but it enables you to obtain a somewhat higher yield than the underlying assets collectively provide. A CEF may hold underlying assets in any of several different categories—corporate bonds, municipal bonds, real estate, preferred stocks, among others—depending on the fund’s strategy. A CEF may also employ leverage (borrowed money) to boost its yield. Leverage has the further effect of increasing the CEF’s price volatility.
Loan Funds
Open-end and closed-end mutual funds and ETFs are available as vehicles for investing in bank loans. The loans that constitute the underlying assets of these funds typically pay interest rates that “float” with a specified, market-determined interest rate. That structure offers some protection against the price declines ordinarily sustained by fixed-rate bonds and preferred stocks when interest rates rise. In addition, loans are typically senior in a company’s capital structure to its unsecured bonds. That’s associated with superior downside protection if the company’s credit risk increases as a consequence of operating problems.
PASSTHROUGH ENTITIES offer certain tax advantages to investors. Three types are described below.
Master Limited Partnerships
A master limited partnership (MLP) is a publicly traded vehicle that’s taxed as a limited partnership. Its profits are passed through to its unit holders, rather than first being taxed at the corporate level. Furthermore, as a holder you can use the MLP’s depreciation and depletion as deductions on your own tax return. These privileges are granted to an MLP on condition that it derive at least 90 percent of its revenues from operations in natural resources or real estate. Note that MLPs issue Schedule K-1 tax documents to investors, which can create a significant administrative burden.
Real Estate Investment Trusts
Real estate investment trusts (REITs) enable investors to invest in portfolios of income-producing properties such as apartment buildings, cell towers, data centers, hotels, medical facilities, office buildings, shopping centers, and warehouses. REITs’ profits are not taxed at the corporate level but are instead passed through to shareholders. REITs can be attractive income investments because they’re required to pay out at least 90 percent of its earnings each year in order to maintain their favorable tax treatment. Distributions to shareholders may include some combination of ordinary income, capital gains, and return of capital. Return of capital is not taxed when received, but it reduces the shareholder’s cost basis, potentially creating a capital gains tax liability down the road. Listed REITs trade on an exchange, while unlisted REITs do not and are consequently less liquid.
Royalty Trusts
A royalty trust is a specialized type of energy-related investment found mostly in Canada. It’s a special-purpose financing vehicle that receives the income produced by assets such as oil and natural gas wells and coal mines. Royalty trusts make monthly distributions to unitholders until the natural resources on which they’re based become depleted. Income is not taxed at the corporate level, but is instead passed through to unitholders. In most cases, the distributions are not recognized by the Internal Revenue Services as taxable events. Instead, they reduce the investor’s cost basis, with the likely resulting capital gain down the road being taxed at the lower capital gains rate, rather than the ordinary income rate.
CONCLUSION
The universe of income investments extends far beyond the familiar categories of stocks and bonds. Diversifying among a few different categories can help you manage risks related to interest rate fluctuations, recessions, and industry-specific developments that affect the financial condition of the income-generating assets. This survey of income investments should not be construed as investment advice. Suitability of the various investments described herein will depend on your specific financial circumstances and risk preferences. Consult your investment advisor and your tax advisor for important details concerning the risks and tax consequences of the investment categories discussed above.
