How to invest for income

When most savers think about income they tend to view stocks and bonds as risky stuff, best left to the experts. Meanwhile, cash Isas imply simple savings with high-street names you can trust. But the new era of low interest rates has changed everything. As we enter another year with rates at record lows even turning negative in some countries investors are rethinking their views.

Taking more risk

If your money is in a typical cash Isa, you'll be incredibly lucky to get an income of much above 2%. That's not likely to change soon. So if you want a higher income, you'll have to take more risks and think like an investor. What does this mean? In simple terms, most savings products have some form of guarantee, with your capital backed by the Financial Services Compensation Scheme (FSCS). Many income investors also use annuity-based products, which are invested in UK government bonds, which are backed by the state. By contrast, investing involves taking risks to boost your income.

So how much risk is involved? Let's assume that the base level for all income is the interest rate, which is still stuck at 0.5%. For investments, the standard guideline rate is the yield you receive if you buy gilts maturing ten years in the future. This is currently near historic lows at 1.35% and is what investors and economists call the risk-free rate (meaning that there is no substantive risk you won't get this if you hold these bonds until they mature). Once you head above this level, you're starting to take the risks that the institution paying you that income might not keep paying. The greater the risk, the higher the yield should be.

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If your target income for an Isa is between the risk-free rate (now 1.35%) and 3%, the risk you need to take should be fairly low. There's a range of choices, such as good-quality corporate bonds, that will fairly safely pay you that much. But once your requirements head above 3%, you're inexorably moving up the risk scale. At between 3% and 4.5%, you take a chance that your capital might be at risk. Despite this, I believe that a smart investor can still put together a portfolio of assets that will give this kind of yield and probably be fairly secure.

Once we reach the 4.5% to 7% range, we move decisively into a new world of risks. Some stocks and alternative investments listed on the stockmarket, such as real-estate investment trusts (Reits), pay out a yield at these levels. However, the value of these investments will fluctuate significantly with the stockmarket. That need not be as scary as it sounds if your investment time span is long, but it's important to keep it in mind. Then we head above 7% and here your risk levels start to increase almost exponentially. Sophisticated investors who understand risk can achieve a yield of 8% or more from a diverse bunch of assets, including the riskiest ("junk") bonds, but this is speculative and not for everybody.

How much time do you have?

So the first issue is to understand your required income level and also how much risk you can take. But you also need to understand other factors that influence your behaviour, such as your investment time horizon As a rough guide, if you might need to access your cash within a five-year time frame, stay well away from equities, riskier bonds and alternative assets.

If your time frame is five to ten years, then it's all right to take some risks, as you should have enough time to recover from any temporary capital losses that result from market volatility. Once we head into the ten-year-plus time frame, you have ample time to recover lost capital via market volatility, so you could take on much higher levels of risk.

Investors should also consider "liquidity risk". This sounds complicated, but it's essentially how quickly you can sell something for cash if cash is needed. Different investments have different liquidity issues, but frequently one discovers that those with the highest yields can be the most illiquid.

Our investment choices

With that in mind, how attractive do different types of income investment look right now? Let's take corporate bonds. The safest bond issuers have purchase prices that are so high and yields so low that one questions whether they represent good value: some of them have bonds yielding less than major governments. Overall, I'd say that you aren't taking many risks up to 3% or 3.5%, but you need to be aware that you're buying very expensive assets. By contrast, I see real value in some higher-yielding corporate credit and emerging-market bonds with yields of 5% to 6%. But the risk some of them don't keep paying is much higher and you also need to be much more concerned about how volatile their market value will be and what price you'll get if you need to sell.

When it comes to shares, many large companies are still trading at high valuations even after the recent slide in share prices. My rough and ready guideline is that large stocks with dividend yields of between 2.5% and 4% are probably a reasonably safe bet for an income Isa. However, some of those yielding above 5% represent better value, but their prices are likely to be much more volatile. For example, I think HSBC sits in this category, with a dividend yield of not much under 8%.

There is also a range of more adventurous options, such as Reits and infrastructure funds. The underlying assets for these vary enormously, but hard assets, such as property, are a popular choice. Secure dividend yields here can easily be 4.5% to 5.5%, but you need to understand that the value of these funds will be volatile, just like shares. However, even more crucially, you need to do some research to understand what these funds are invested in and what the outlook for their assets is. For example, where are we in the real-estate cycle? Will governments pay their debts on infrastructure projects and not renegotiate subsidies and price deals?

Pulling it all together

Let's finish by pulling together all these different observations and ideas into a set of simple portfolio guidelines.

If you are after a lower-risk return of under 3% per year and have a short time horizon, stick with a portfolio that is 50% or more in bonds and around 20% in cash. Your allocation to equities and alternative assets should be below 20% for each category.

Investors willing to take some risks could aim for a yield of 3% to 4.5%. You should have a longer time horizon of, say, five to ten years. Put roughly 50% in bonds and then split the remaining half of the portfolio equally between equities and alternative assets.

An investor who wants to get a yield of more than 4.5% from a portfolio of investments needs to increase their risk appetite and be willing to sit tight for a period of ten years or more. In this case, I'd be looking to split the portfolio between equities, alternative assets and bonds, with a third in each asset class. In the last category, you probably need to focus more on riskier corporate bonds.