A new dawn for income investing

Income focused investment strategies have increased in popularity over the past few years as some investors shy away from the higher volatility of traditional investments like shares.

So what’s income based investing all about and how do you make the most of this approach to investing?

Short term solution

The objective of income based investing is to deliver a stable and sufficient income stream while at the same time reducing underlying capital volatility.

On the surface, simply shifting into cash and fixed income based strategies aims to achieve this. With term deposits and fixed income funds having delivered returns of 7% to 10% or higher with negligible capital volatility, it seems to be a perfect solution to the problem.

If such returns could be sustained long term, then this could be a reasonable investment solution.

Unfortunately, it’s highly unlikely that cash and fixed income based investments alone will generate this level of returns on a sustainable basis in future.

Average term deposit rates have fallen below 6% following interest rate cuts by the Reserve Bank of Australia and bond funds are seeing much lower yields at the moment.

This suggests future returns from these strategies on average are likely to be markedly lower over coming years.

In search of higher yields

However cash and bond strategies are just one element of income focused investing.

The Australian sharemarket also contains higher dividend paying share investments.

Apart from a higher potential after-tax return, the benefit of a dividend focused strategy is that dividends tend to grow over time in line with corporate profitability. This growth provides some protection against rising cost pressures.

The potential dividend returns available from investing in the local share market are also relatively quite attractive, provided profits are sustained. The average dividend yield of the Australian share market was almost 5% pa at the start of 2012.

Add on the after tax franking benefits available to retirees then this might be boosted a further 1.5% to 2%.

Even more appealing, the higher yielding sectors of the local market are offering dividend yields around 7% to 8% pa or higher at present. Add in franking credits and the after-tax yield rises to closer to 9-10% pa.

Provided dividends can be sustained and grown over the long term, then the yields on offer in Australian share market would seem to meet many investors’ needs.

Balancing yield with volatility

However, there’s a potential sting in the tail with this strategy. While some of the higher yielding parts of the Australian share market have also been relatively less volatile capital investments, the Australian banks for instance displayed significant capital volatility in 2011 despite their high yield.

For investors who want higher yields with lower risk, this high volatility could be a problem.

So is it possible to develop strategies which combine higher, more predictable income returns, with lower capital risk on a sustainable basis?

Blending for balance

There are solutions to this, but they’re likely to require more sophisticated approaches. Blending a range of investment strategies that deliver sustainable income returns while actively managing capital risk could be an answer.

Such strategies are likely to employ various combinations of cash and bond based investments with dividend focused share investments as well as other income producing strategies such as international shares, credit, absolute return and equity income strategies. This helps maximise the diversity of sources of return as well as minimise investment risk.

If you would like to discuss an income investment strategy, talk to your financial adviser who can work out the best approach for your needs.