How to Invest for Income

How to Invest for Income March 13, 2013

With the stock market moving once again into record territory, maybe it’s time to wonder if this represents a solid continuation of the bull market that’s been in place since 2009, or if it means that a reversal is in store. Though it isn’t fashionable to say that stocks are affected by price levels, it is nonetheless impossible to ignore that we are moving into uncharted territory. And that means an extra layer of risk.

Will the market continue to rise, or is the recent surge signaling the beginning of the next market downturn? As an investor, this is a time to begin looking to broaden your investment base. One of the best ways to do that is to invest in income, and there are various ways to do this.

Short-term vs. Long-term Income Securities

Since income type investments are a diversification to the risk involved in stocks, you may want to begin shifting some of your investment capital into them now. But all income investments are not equal, and a critical distinction must be made between short-term and long-term income securities.

One of the considerations that we have that’s almost unique to our time is the fact that we have record low interest rates. That complicates investing for income in general.

In this rate environment, rates probably have nowhere to go but up. And since bond prices move in inverse proportion to interest rates, rising interest rates will convert into declining security prices. If you invest in long-term interest bearing securities, the value of your holdings will drop should rates rise.

This makes a strong case for investing in short-term income securities, particularly those with maturities of one year or less.

What are the choices?

Corporate Bonds

Corporate bonds are usually long-term in nature, say 10 years or more. While they pay above average interest rates, the risk associated with long-term bonds in general is probably unacceptably high at this time. A shift in interest rates, from flat to increasing, will mean a declining principal value of your investment. Sure, long-term bonds will pay the full face amount if held to maturity, but if you decide to sell your securities in advance of maturity in order to purchase higher yielding securities, you’ll take a loss on the sale.

For this reason corporate bonds are probably best avoided entirely because of the risk of principal loss.

Treasury Securities

Treasury securities are interest-bearing securities issued by the United States government. They run the gamut as income securities go, maturing in as little as 90 days to as long as 30 years.

Should interest rates begin to rise – which could be the very trigger causing the stock market to turn down – the safest treasuries would be those of the shortest term.

Not only will short-term securities (those maturing in one year or less) offer the best protection of principal, but because they will mature in a matter of months, your capital will be freed up to take advantage of higher interest rates as they become available.

And unlike corporate bonds, treasuries are backed by the full faith, credit and taxing power of US government, so the risk of default is virtually zero.

Certificates of Deposit (CDs)

CDs are similar to treasuries in most respects, except that they are insured by the US government (by the FDIC, up to $250,000 per depositor) rather than issued directly by it.

CDs are actually investment contracts with the bank to pay a certain interest rate over a specific period of time. Once again, in order to avoid risk of principal, and to keep yourself in a position to take advantage of higher interest rates in the future, you‘ll want to stay with the shorter-term securities – those with maturities of one year or less.

Dividend Stocks

Another way to invest for income, but while still staying in the stock market, is to invest in dividend stocks. Dividend stocks typically pay dividends that offer a yield that’s higher than what is being paid by the general stock market, and are often comparable to or even higher than competing rates on treasuries and CDs.

Dividend stocks do have risk of principal, and that can be negatively affected by rising interest rates or by a general decline in the stock market. However, they offer you an opportunity to participate in a market rise while paying you a steady income in the process.

Income-based Mutual Funds

If you like the idea of investing in dividend stocks, but don’t like having to build and manage your own portfolio, you can simplify the process by investing in income-based mutual funds.

These funds can go by different names, including income funds, growth and income funds, equity income funds, and other titles. Not only do they make the process of investment for income simpler, but they also offer diversification that will prevent you from taking a big loss in the event one of the securities within the portfolio collapses.

With the stock market in record territory, and interest rates at all-time record lows, now may be the perfect time to begin looking to diversify your holdings outside the stock market. Income investments are one of the best places to go. Don’t be scared off by the low interest rates – the reason for investing in income securities is to preserve your asset values so that you’ll have capital to invest in higher-yielding securities later, and also to scoop up bargains when the stock market goes on sale.

Are you investing for income? Leave a comment and explain how and why!

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