Investing basics: How to build an income portfolio

An income investor’s portfolio can benefit from diversification – blending a range of investment areas so it is not overly reliant on one area or a single economic scenario.

| 12 min read

With interest rates close to zero and little prospect of a significant improvement in the near term, many investors have been considering investing to provide much-needed income, including through pension drawdown.

This means foregoing the security of cash and taking on more risk. All investments can fall in value as well as rise, so it is important to hold a range of assets to avoid over-reliance on one or a small number of areas.

How to measure income

You can get an idea of how much income an investment produces by looking up its ‘yield’ – generally this is the amount of income it has paid over the past year divided by its price, and it is expressed as a percentage. For instance, a share valued at £1 that has paid 5p per share in dividends from its profits over the past year has a yield of 5%. This could be different going forward because the dividend could be higher or lower, plus of course the price might change, but it can give a useful indication of the possible amount on offer.

It’s also important to note that some yields you may come across are forward looking or ‘prospective’ rather than historic. This is especially the case with bonds - loans to institutions who wish to raise finance. In the case of corporate bonds, the borrower is a company, and for gilts the borrower is the UK government. You should always treat yields as variable and not guaranteed.

Deciding on strategy

When investing for income you are going to need to decide on your income strategy, method of taking income and how much. Taking income means you don’t benefit as much from the ‘compounding’ of returns compared with investing for growth, which means getting your strategy right from outset is very important – especially if you are relying on this income rather than it being a ‘top up’ to guaranteed income from an occupational pension, state pension or an annuity.

There’s two main approaches, both of which are perfectly valid: invest for ‘total return’ and withdraw what you need each year; or invest in income producing assets (dividend-producing equities, bonds, property etc.) and take the ‘natural income ’ these investments produce.

The natural income approach can restrict you in terms of maximising returns because non-yielding or low-yielding areas would be excluded if you are maximising income – and they might perform better than low or non-yielding assets. However, the natural income approach means you are never selling capital (provided that the income alone meets your needs), and it ensures this remains intact to generate future income.

Income producing areas can also be less volatile – though of course there are no guarantees – which can help, plus keeping to natural income can mitigate the effects of ‘pound cost ravaging’. This is the term used to describe how the impact of capital withdrawals amplify the effect of the volatility of returns on a portfolio.

Smoothing returns can be important compared with the ‘accumulation phase’ of investing when volatility doesn’t matter so much and can even work to your advantage. It is much more challenging to manage a portfolio where income is being taken. A very diverse approach that combines a bit of natural income with maximising total return tends to work best, but obviously it depends on income needs too. The less income required the easier it is.

By blending a variety of investments that are ‘uncorrelated’ (i.e. their price movements are largely independent of one another rather than moving up and down in tandem) it is possible to build a portfolio more resilient to market fluctuations but that can still deliver a consistent level of income. But what are the main building blocks to consider when constructing a diverse portfolio for income?

A growing income from equities

Of the major asset classes available to income investors, shares or ‘equities’ are appealing because they offer the potential for a growing income as profits increase. Although investing in the stock market generally means accepting a greater degree of ups and downs, it offers the greatest potential for growth in both income and capital. Shares represent a stake in a business, and as a shareholder you participate in the growth of a business if it does well and often receive a share of the profits through dividend payments.

A ‘default’ position might be to roughly align your portfolio with the relative size of markets, in which case you would have a lot of your money (50-60%) in the US markets and the remainder split between Europe, UK, Japan and Emerging Markets to get a good spread. However, the US market doesn’t have a high yield, which is why some income investors would have less there.

Global equity income funds are one option worth considering. They invest in dividend producing shares from around the world ensuring broad geographical and sectoral coverage. There is also a case to made for the UK.

With the FTSE 100 yielding around 3-4% a year presently (variable, not guaranteed) there is an attractive starting income on offer, as well as the potential for the income to rise over time to help combat the effects of inflation. An advantage of UK shares and funds is that dividends are in pounds, so income investors tend to be less impacted by currency movements.

A steady income from bonds

To balance the volatility of equities and help smooth overall returns, investors often add less volatile investments to their portfolio, notably bonds.

Typically, bonds pay a fixed amount of income each year (known as a coupon) and repay the original capital at the end of the term. Income varies according to the issuer of the debt. More risky companies have to pay a higher yield to attract investors, while low risk entities (such as many governments) can issue debt with low yields, perhaps in line with general inflation or interest rate expectations, reflecting the minimal risk of default (non-payment of income or capital).

Between issue and repayment investors can buy and sell bonds just like any other investment, so values fall as well as rise and you could get back less than you invest. Prices will change according to several factors including changing interest rates, inflation expectations and the creditworthiness (or “rating”) of the underlying company or entity. In the event of bankruptcy, bond holders are a creditor and could receive a proportion of remaining assets, if there are any, once the company is liquidated. This is an important distinction between shares and bonds, as in the event of liquidation an shareholder would likely be last in the queue to receive any money and could receive nothing at all.

Bonds are considered lower risk than equities but have lower potential upside and don’t usually provide an income that grows. However, their lower volatility and ability to provide a consistent income makes them attractive as a way to balance an income portfolio, and more cautious investors may decide to have a higher weighting to bonds than equities. Over long periods bonds and equities do not tend to move in tandem, though over shorter periods they can.

Higher yield options

Investors are naturally attracted to investments that produce a high level of income. However, a high yield can also be a warning sign. There is likely to be a very good reason why an investment yields so much. If it is a share, there could well be expectations of a dividend cut. For bonds, higher yield means higher risk, and more chance of default and capital loss. However, there are funds designed to produce high levels of income while aiming to control these risks through diversification, and sometimes through more sophisticated techniques including the use of derivatives.

These can sometimes be useful to bring something different to a portfolio. For instance, as well as providing a higher yield than safer, investment grade bonds, high yield bonds react differently to changing economic circumstances. They are more likely to be resilient in a strong economic environment where company bankruptcies are falling, whereas the threat of higher inflation and interest rates in these circumstances may have a greater effect on gilts (UK government bonds) and other bonds with lower yields.

Alternative asset classes

A ‘traditional’ portfolio comprises mainly, or perhaps only, equities and bonds. Yet there are other asset classes that can help diversify a portfolio, and arguably these are especially important at present. Some investors are concerned that low interest rates and a flood of money into markets (from central banks trying to mitigate the effects of Covid lockdowns) have led to a greater tendency for bonds and equities to rise and fall in concert.

Many ‘alternative’ investments such as commodities and targeted absolute return funds don’t provide an income. They can still be part of an income portfolio, but their inclusion would reduce the overall level of income produced, and it would be necessary to weigh up their benefits in terms of diversification against this. Fortunately, there are several other areas that do provide an income as well as diversification potential.

UK commercial property funds investing in ‘bricks and mortar’ assets generate rental income but were among the most prominent casualties of both Brexit and Covid uncertainty. Many open-ended funds (such as unit trusts and OEICs) imposed exit penalties or closed to dealing altogether as investors rushed to sell units. Now conditions have stabilised in commercial property most funds are open again and yields remain attractive in the region of 4%. However, we generally prefer investment trusts for exposure to the area rather than open-ended vehicles as these are more appropriate for investing in “illiquid” investments such as physical property.

Alternatively, infrastructure funds have been growing in popularity over the past few years as they aim to provide a good yield at a time of low interest rates. Typically, these funds own a variety of assets, such as hospitals, schools and toll roads, which are often backed by long-term revenue streams from local or central government and tend to be uncorrelated to the wider economy. We expect the sector to grow as it provides much-needed finance for vital projects such as the transition to renewable energy, and it potentially provides investors with an attractive (and potentially rising) income as well as welcome diversification.

There’s a rundown of the various ‘alternative’ investments to consider. Blending a variety of these in a portfolio alongside equities and bonds can reduce risk while still aiming to generate decent returns.

Investment ideas

If you are looking for investments to fill a gap in your portfolio our Direct Investment Service Preferred List could help. This collection of investments is chosen by our Research Team to represent our best ideas across the major sectors.

Alternatively, for those simply wanting a well-diversified income portfolio in a single investment, Charles Stanley Monthly High Income is monitored and rebalanced by Charles Stanley experts. It covers the asset classes mentioned above and presently yields around 4% (variable, not guaranteed). The fund takes a relatively is limited to a maximum of 35% in equities, means it is aimed at investors with a medium-low risk outlook – so although it is a relatively cautious investment it is subject to market fluctuations and can fall in value as well as rise.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

Investing basics: How to build an income portfolio

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The information in this article is based on our understanding of UK Legislation, Taxation and HMRC guidance, all of which are subject to change. The tax treatment of pensions depends on individual circumstances and is subject to change in future. This article is solely for information purposes and does not constitute advice or a personal recommendation.

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