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A Beginner's Guide to Income Investing

Keith Noonan, The Motley Fool

Income investing is a wealth-building strategy that involves assembling a portfolio of assets that generate dependable cash payouts. For most investors, that means putting together a collection of dividend-paying stocks and high-quality bonds that can be counted on as a source of cash requiring little, if any, extra work or input from the investor.

A well-constructed portfolio of dividend stocks and bonds can be one of the most accessible and rewarding routes to building a substantial stream of "passive income." As Warren Buffett once said, "If you don't find a way to make money while you sleep, you will work until you die." These words from the Oracle of Omaha might sound a bit gloomy, but they highlight the important role that passive income streams play in building wealth and how being financially prepared can open the doors to living the kind of life you want.

A bag with text on it that says Dividends.

Image source: Getty Images.

Who is income investing for?

Some people think that income investing is only for older investors and retirees, and there are some valid reasons for this association and its persistence. However, the truth is that income-generating investments can be valuable financial vehicles for people of all ages. Stocks that pay dividends have tended to outperform those that do not, and high-quality bonds are one of the safest ways to preserve wealth and prevent the purchasing power of your savings from being eroded by inflation. As such, there's no reason to think too narrowly when it comes to who should be employing income-investing strategies.

The ideal makeup of an income-generating portfolio will vary depending on what the investor is hoping to achieve and the degree of risk that he or she is comfortable with. As such, it's helpful to have an understanding of the different types of assets that can make up an effective income-generating portfolio, some metrics and characteristics to use and look for when evaluating different candidates, and a clear idea of what your goals are in order to figure out the strategies and holdings that best suit your individual needs.

How do bonds work?

Bonds are a type of fixed-income investment, meaning that they pay a designated amount along a predetermined schedule. When a person buys a bond, they are loaning money to a government or company. At the end of the agreed-upon loan period specified with the bond (referred to as "maturation"), the bond holder can cash in the bond to receive the principal value. The rate of interest generated on this loan will tend to vary based on the length of the bond maturation and the amount of risk of default.

There are two main types of bonds.

  • Government bonds
    Government bonds are essentially money loaned to a particular government that yield a designated amount of interest annually. U.S. bonds are generally thought of as a pretty safe investment because the U.S. government has historically been one of the most stable governments in the world, if not the most stable. Certain government bonds also have special tax advantages, such as tax-free municipal bonds.
    Investors might also want to invest in foreign bonds as a means of diversifying. However, depending on the country in question, this can come with increased risk of not getting your principal repaid upon maturation or not getting the true value of your principal back because of either political instability or wild currency fluctuations. If a foreign government doesn't make good on a bond, it can be difficult to get restitution, because you may not have easy access to that country's court systems.
  • Corporate bonds
    Corporate bonds have the same basic setup as government bonds but with a few differences that are worth noting. As the name suggests, these bonds have investors loaning money to a given company at a fixed rate over a given time period. Just as with government bonds, the interest on the bond will be higher the riskier the company is. However, unlike government bonds, you will usually have to purchase corporate bonds in 1,000-bond lots.

Bonds are typically seen as safer than dividend stocks, but that's not always true. If a bond has a high interest rate, that tends to be because of heightened risk that the country or company will not be able to pay back the initial loan amount. Bonds that have high yields but are also at high risk of default are sometimes referred to as "junk bonds." Investors can use bond ratings from third-party ratings agencies like Moody's and Standard and Poor's to assess the likelihood that their principal will be repaid.

In general, higher bond yields tend to have higher risk of default, so investors have to keep risk and reward dynamics in mind. Investors can also purchase a bundled package of bonds in order to diversify and further reduce risk.

What are dividend stocks?

When you own stock, you own a portion of that company. That means that your shares generate a percentage of that company's earnings and free cash flow (FCF). Not all companies actually distribute cash directly to their shareholders, but those that do are referred to as "dividend stocks."

Dividends are a way for companies to pass earnings along to shareholders. Dividends are usually paid out of a company's free cash flow -- which is typically defined as operating cash flow minus capital expenditures. Companies can also dip into their cash piles or take out debt to finance dividend payments, but investors tend to look less favorably on these methods of funding dividend distributions.

ETFs and mutual funds

In addition to individual dividend stocks, investors can also buy exchange-traded funds (ETFs) or shares in mutual funds. ETFs are securities that bundle multiple assets together (most often stocks, but some include or specialize in bonds and other asset classes) and are purchased on trading exchanges. ETFs usually track an index. Mutual funds are managed securities that can bundle together stocks, bonds, and other assets, tend to be actively managed, and are purchased directly from the fund manager or through a broker.

Unlike stocks, mutual funds and ETFs have managing expenses that are deducted from returns annually. Most mutual funds are actively managed and tend to have higher expenses than exchange-traded funds. ETFs can be actively managed or passively managed, with most funds falling into the latter category because their components are chosen to replicate an existing index. This means that unlike mutual funds, in which managers actively tinker to try and achieve desired results, the components that make up most ETFs are chosen by an established, unchanging set of criteria -- such as being part of the S&P 500 index or being part of an index consisting of stocks in a particular industry.

Fees may look small on paper, but they often add up to put a significant dent in performance over time. Investors will have to weigh these fees against expected performance and the history and quality of a fund's management.

Other types of income-generating investments

Stocks, ETFs, bonds, and mutual fund shares will make up the core of most income-focused portfolios, because they tend to have higher yields compared to other vehicles. But it's also worth touching on a few other ways that investors can put their cash to work.

  • Certificate of deposit
    Certificates of deposit, or CDs, are a type of fixed-income investment that's similar to a bond or a savings account. But instead of money being lent to a government or a company, it's lent to a bank. The longer the CD loan's term is, the better the interest rate investors will typically be able to get.
    Rates investors get on these fixed-income investments will often be lower than those one loans of comparable time periods for bonds, but the upside is that they are insured by the FDIC up to $250,000, which means that you should be able to recoup the principal even if the bank in question goes out of business.
    This lower-risk, lower-yield income investment vehicle makes CDs well suited for retirees who are looking to preserve wealth rather than build it and to help combat the effects of inflation. However, investors will typically have to pay a penalty if they wish to redeem their CDs before the originally specified date.
  • Savings account
    Interest rates will tend to be comparatively low with savings accounts compared to other income-generating vehicles, but there are also advantages. The money put in the bank is FDIC insured, and it's also easily accessible, so you should be able to withdraw it on very short notice without incurring any penalty.
  • Money market accounts
    Money markets are similar to savings accounts in that they have you depositing money into a bank account at interest, but they tend to offer higher interest rates in exchange for giving up some of the flexibility that comes with savings accounts. As with other bank-backed income generators, money markets are backed by the FDIC so long as the bank is insured.
Stacks of gold coins.

Image source: Getty Images.

What is a payout ratio?

A company's payout ratio is the percentage of its earnings or free cash flow (FCF for short) that goes toward covering its dividend distribution. Payout ratios are calculated by dividing annual earnings or FCF by the total dollar amount of dividends that a company has distributed or will distribute in a given year. A payout ratio above 100% indicates that a company is generating less cash than it's spending on paying its dividend and will have to tap into its cash assets or take out debt in order to fund the distribution. This dynamic typically isn't sustainable, and it often signals that a dividend cut or suspension is on the way. Companies with low payout ratios are often seen as having more leeway to raise their dividends, but they may also have other needs (such as operating in relatively young or otherwise capital-intensive industries) that prevent them from delivering big payout growth.

What is payout growth?

Payout growth is simply the extent to which a company has increased its payout per share over a given period of time. A payout growth rate can be calculated by taking the dividend at the ending point of a given time period, subtracting the dividend value at the starting period of your comparison, and then dividing the resulting value from the dividend at the starting point of your comparison.

If a company buys back stock and retires shares (meaning they are eliminated from the total outstanding share count), it reduces the number of dividend-generating shares. This means that buybacks can allow a company to increase its dividends paid per share over a time period without a corresponding increase to its total dollar-amount distribution because fewer shares receive dividend payments.

What is dividend yield?

Dividend yield is the percentage that a company's annual dividend payout represents as a percentage of the company's stock price. Yield is calculated by dividing the company's annualized dividend by its stock price.

So if a stock pays out $1 in dividends per year and is priced at $50 per share, it would have a yield of 2%. If you owned 50 shares of the company, you would generate the equivalent of one share's worth of value through dividends each year. Depending on how you had your payment options set up, you would have either received $50 in returned income or added a new share to your holdings (if its stock price remained exactly flat) through a dividend reinvestment program (DRIP). Investors will often wind up owning fractional shares as a result of enrolling stocks in DRIP programs, and these fractional shares still pay dividends and can be sold just like full shares provided you are operating through a major brokerage.

What is the benefit of reinvesting dividends?

A dividend reinvestment plan (or DRIP for short) will allow you to take advantage of the power of compounding. A stock's dividend yield might not seem like much on paper, but even small returns add up and will work to purchase additional shares. These additional shares then generate their own payouts, paving the way for snowballing growth over the long term -- especially if the stock's share price sees substantial gains.

If you do not need the money you will generate from dividends in order to cover your living expenses or put accessible cash in your accounts, reinvesting payouts can work to your advantage. Shares that you acquire through DRIP investing will also be commission free. On the other hand, if you think that money generated through your dividend payouts would be better invested in another company, enrolling in a DRIP for that stock wouldn't make much sense.

How often are dividends paid?

Dividends are paid according to schedules set by the individual companies. Most companies will pay their dividends on a quarterly, biannual, or annual basis, but some will opt to distribute payouts monthly. Companies can also opt to implement a special dividend -- a nonrepeating and otherwise unscheduled distribution of cash to shareholders.

Do you have to pay taxes on dividends?

In most cases, your dividend payouts will be taxed at the long-term capital gains rate of 15%, although the rate can range from 0% to 20% depending on the circumstances. If you are set up for a DRIP in a standard account (meaning one that isn't an IRA or other type of tax-privileged account), you will still need to pay taxes. As an example, let's say you owned 100 shares of a stock that yielded 2%, and you reinvested the $200 in dividend payouts back into the stock through a DRIP. You'd still be required to pay taxes on the $200 you reinvested.

There are ways to minimize the amount you will be taxed on by shifting the timing of taxation in your favor, most notably via individual retirement accounts (IRAs). The downside to these accounts is that you will have to leave the money in them until you are at least 59 1/2 years of age or you will be hit with removal fees, but they are still very helpful tools for investors. There are two types of IRAs -- traditional IRAs and Roth IRAs.

Traditional IRAs allow you to defer the taxation of income that's used to invest in this type of retirement account. Putting funds in a traditional IRA will allow you to take an equivalent deduction from your taxable income and is a vehicle for reducing your overall taxes owed in a given year. However, withdrawals from a traditional IRA account will then be taxed at normal income-tax rates. Most people will generate less income when they are in retirement, so deferring taxation on a portion of your income until you are in your nonworking years can mean that it will wind up being taxed at a lower rate.

With a Roth IRA, you will pay income taxes on the money that you put into your account in the year that you make the contribution, but it will not be taxed at an additional rate when you withdraw money from the account. This dynamic makes Roth IRAs especially useful for income-focused investors who are still many years away from retirement, because it allows dividend payments to accumulate and put the power of compounding in motion without the cash or new shares generated from reinvesting being taxed at the time of withdrawal.

What is dividend growth investing?

Dividend-growth investing involves selecting stocks with rapidly increasing payouts even if they offer relatively small yields -- with the understanding that they can build to having much bigger yields over time. A stock might have a yield that looks small compared to the S&P 500 index average yield or the U.S. 10-year Treasury bond yield. However, if the company were to raise its payout at an average annual rate of 15% over a period of five years, your yield on those shares would have more than doubled at the end of the period.

Companies that pay huge dividends are often growing earnings at slower rates relative to the rest of the market and will often deliver relatively small payout increases. Meanwhile, companies that are growing their earnings at faster rates compared to mature companies in industries like telecommunications or industrials can be better positioned to deliver rapid dividend growth. Dividend-growth stocks can offer investors a good balance between a growing returned income component and a better chance at seeing the stock price go up than those that already offer big yields.

The importance of payout-growth streaks

It's a good idea to look for companies that have a history of delivering consistent annual payout growth. A company choosing to cut its dividend often signals a faltering business, and a long track record of dividend increases can point to the likelihood of continued payout growth.

After a company has a multidecade streak of annual payout increases, dividend growth becomes an expected part of stock ownership. That company can count on shareholder backlash if it fails to deliver a payout increase -- or, even worse, cuts its dividend. You'll want to look for companies that have sturdy businesses that are capable of thriving over long time periods, but shareholder expectations can also help to encourage companies to continue growing their dividends during recessions or slow periods for the business.

Stacks of coins in front of a bar chart showing an increase from left to right.

Image source: Getty Images.

Good stocks and ETFs for an income-investing portfolio

With some important metrics and criteria for dividend stocks established, it's a good time to move on to a sample of worthwhile income-generating securities. Below, you'll find a list of high-quality income-generating stocks and ETFs that are worth considering for your portfolio.

Security Industry Advantages
Vanguard High Dividend ETF (NYSEMKT: VYM) N/A
  • Bundles more than 400 high-yield stocks together, offering investors diversified exposure to income-generating securities
  • Expenses that are far below the average of other funds with similar holdings
Vanguard Dividend Appreciation ETF (NYSEMKT: VIG) N/A
  • Bundles nearly 200 stocks with strong histories of dividend growth together, making it easy to build diversified exposure in the category
  • Expenses that are far below the average of other funds with similar holdings
PepsiCo (NASDAQ: PEP) Food and beverage
  • Above-average yield, fantastic history of annual dividend growth, and reasonable payout ratios
  • Strong brands and huge manufacturing and distribution advantages put the company in position to be a long-term leader in its industry
Brookfield Infrastructure Partners (NYSE: BIP) Infrastructure/natural resources
  • High yield and manageable payout ratios
  • Strong position in an industry that faces little room for disruption
The Walt Disney Company (NYSE: DIS) Entertainment
  • Rapid dividend growth and low payout ratios that suggest plenty of opportunity for payout increases over the long term
  • Global leader in entertainment with an unmatched catalog of big franchises
Realty Income (NYSE: O) Commercial real estate
  • High yield, great history of payout increases, distributes payments to shareholders on a monthly basis
  • Legally required to pass income along to shareholders because of its status as a real estate investment trust (REIT for short), and looks positioned to thrive despite shifts in the bricks-and-mortar retail market

Vanguard High Dividend Yield ETF

Vanguard has an excellent reputation in the financial services space, and the company's High Dividend Yield ETF tracks the FTSE High Dividend Yield index and is a preferred vehicle for diversified income investing. The passively managed fund has an expense ratio (the cost of annual expenses divided by the cost of a share in the fund) that's substantially below the average costs of similar funds from competitors.

The fund bundles together more than 400 different stocks that have above-average dividend yields from a wide variety of industries, with the vast majority of holdings in U.S.-based companies. The Vanguard High Dividend Yield ETF's top holdings by weight include Johnson & Johnson, JPMorgan Chase, ExxonMobil, Procter & Gamble, and AT&T.

Vanguard Dividend Appreciation ETF

Vanguard's Dividend Appreciation ETF is a passively managed fund that tracks the NASDAQ US Dividend Achievers Select index and combines more than 180 stocks that have strong payout growth track records. Like the company's High Dividend Yield ETF, Vanguard's dividend-growth-focused fund has an expense ratio that is far below the average cost of similar funds and stands out as a great vehicle for investing in a wide range of income-generating stocks.

Vanguard's Dividend Appreciation ETF will sport a smaller yield than the company's high-yield-focused ETF, but dividend-growth stocks have tended to put up strong performance as a category, and the fund offers an easy way to build broad exposure to stocks that have reliably delivered payout increases. The ETF's holdings are well diversified across sectors, and its biggest holdings by weight include Microsoft, Visa, Walmart, Procter & Gamble, and Johnson and Johnson.

PepsiCo

PepsiCo is a well-managed company that has a consecutive annual payout growth streak that spans multiple decades, and its stock has historically offered a yield that's significantly above the market average. While the company has faced some pressures, its massive global distribution network and supply chain advantages create a formidable moat, and its business looks sturdy enough to keep cash flowing back to shareholders for decades to come.

Soda sales have been slipping in the U.S., but PepsiCo still has a strong collection of blockbuster brands across its beverages and snacks segments -- as well as a growing international footprint that should help the company maintain dividend growth. The company has diversified its product offerings by building up its Frito Lay snack division, and it's working to further expand its portfolio into healthier food and drink offerings.

PepsiCo's stellar payout-growth history and above-average yield have long made it a favorite among income-focused investors, and it looks like the company is on track to meet the shifting demands of the snack-and-beverage industry and continue delivering wins for long-term shareholders.

Brookfield Infrastructure Partners

Brookfield Infrastructure Partners is a master limited partnership that invests in, owns, and operates a wide range of dependable, infrastructure-related businesses in fields like transportation, energy, utilities, communications, and sustainable resources like timberland and farmland. Its successful track record on those fronts and strong dividend growth have allowed the company to deliver a compound annual return of roughly 15% from 2008 to 2018 -- impressive performance for a relatively low-risk business. More importantly, Brookfield Infrastructure anticipates that its current assets and future acquisitions will allow it to deliver a long-term annual return on equity averaging between 12% and 15%.

The company's dividend is already well covered, and infrastructure businesses face relatively little risk from new competitors. With a core business that looks fairly recession proof, moves to expand further into areas like telecom and toll roads -- as well as and growth markets like India and Brazil -- have it positioned to make good on its long-term goal of increasing its payout at an annual rate between 5% and 9%.

The Walt Disney Company

Disney's dividend yield usually comes in below the market average, but the stock's income component has considerable appeal when viewed in the context of the potential for long-term payout and earnings growth. The House of Mouse has been delivering rapid payout growth and generates enough earnings and free cash flow to keep its payout ratios low. Its fantastic brand strength and highly integrated business model put it in position to thrive and continue rewarding shareholders despite changes in the media landscape.

Disney has leaned heavily on its media networks segment, and the impact of cord-cutting and declining ratings at its hugely important ESPN network have been taking steam out of that growth engine. Even so, the company's filmed entertainment, theme parks, and consumer products divisions continue to look strong, and dependable consumer demand for entertainment combined with the company's talent for creating new properties should create sales catalysts across each of its four major segments and allow it to continue boosting its payout.

Realty Income

Realty Income is a real estate investment trust (or REIT for short), which means that it generates sales and income primarily from leasing commercial properties to businesses and is subject to some industry-specific financial standards. The company has to return at least 90% of its earnings to shareholders in the form of cash dividends because of these requirements and must also count standardized depreciation of property assets (many of which actually increase in value annually) against earnings. While that latter stipulation has a distorting effect on its reported profits, investors can be virtually certain that Realty Income won't suspend its payout.

The company primarily rents out properties for freestanding retail business, which might be concerning in light of the effect that e-commerce is having on brick-and-mortar outlets. However, Realty Income boasts a very high occupancy rate because its customer base primarily consists of companies with businesses that aren't dramatically impacted by the rise of online retail. Realty Income also distributes payouts to shareholders on a monthly basis -- a characteristic that could make the stock appealing for retirees looking to supplement their Social Security income.

Intelligent income investing is a path to financial success

The dividend stocks profiled above represent just a small handful of the worthwhile income-generating securities that investors can explore and employ in their wealth-building pursuits. There's no surefire, one-size-fits-all approach to income investing that will meet the needs of every investor and guarantee success, and investors should always be researching and evaluating the assets and strategies that best suit their needs. That said, building a portfolio around income-generating stocks backed by high-quality businesses and cost-effective ETFs and adding some bonds for their stabilizing, defensive effects is an astute and time-tested way to put your money to work for you and achieve your long-term financial goals.

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Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Keith Noonan owns shares of AT&T and Walt Disney. The Motley Fool owns shares of and recommends Microsoft, Visa, and Walt Disney. The Motley Fool is short shares of Procter & Gamble and has the following options: long January 2021 $60 calls on Walt Disney, short October 2019 $125 calls on Walt Disney, and long January 2021 $85 calls on Microsoft. The Motley Fool recommends Brookfield Infrastructure Partners and Johnson & Johnson. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com