The catch to income investing

JOHN REKENTHALER, vice president of research for Morningstar, makes us take a fresh look at income from investments.
By Morningstar |  15-07-22 | 

Readers in the U.S. sometimes chide me for writing the term “annuity income.” Technically, they point out, annuities do not distribute pure income, meaning cash that has been generated from their portfolios’ investments. Instead, annuity payouts blend 1) genuine income with 2) realized capital gains and 3) return of capital.

Their admonishments are justified. Annuities distribute not only the profits earned by the investor’s principal, but also the principal itself.

There are other investments that are also generally regarded as producing “income” but return the buyer’s capital, albeit implicitly rather than explicitly. Though I write for a U.S. audience, I urge Indian investors to give this a read.

Equities: Lower Capital Growth

Neither high-dividend stocks nor option-income equity strategies return investor capital. As with their low- or no-dividend siblings, high-dividend stocks pay their stated yields but make no distributions from principal.

The same holds for option-income equity strategies, which disburse 1) the yield from their stocks and 2) short-term capital gains from selling call options.

Unavoidably, though, the two tactics involve trade-offs. Investors in either strategy receive more today but less tomorrow. Companies that distribute high dividends cannot plow those monies back into their businesses, which therefore limits their future growth. For their part, option-income equity strategies must forfeit their portfolio’s biggest winners when the call options that sold are exercised. Over time, those opportunity losses eat into the strategy’s principal.

There is nothing wrong with arrangements like this. High-dividend firms usually lack strong growth prospects, so distributing profits to shareholders rather than reinvesting them into their operations makes good business sense. And if option-income equity strategies give up the right to own certain stocks, they are paid for making that concession.

Investors should understand the implications of high-paying equity strategies.

  • Because they hold stocks, high-dividend and option-income equity strategies do grow their capital bases.
  • Investors who spend the distributions they receive from those investments, rather than reinvesting the proceeds, will not be able to match the capital growth of the overall stock market.

Bonds: Capital Erosion

Less overt is the capital erosion caused by high-paying bond strategies. Most high-yield bond investors do not expect their securities to be a capital drain. Nor do those who own option-income bond strategies, which invest in the same fashion as their equity counterparts but with bonds rather than stocks.

That junk bonds and option-income strategies are riskier than simply owning government bonds is well understood. However, that risk is typically framed as producing more volatility, not as potentially harming principal.

But capital erosion with such strategies is inevitable.

  • The underlying deal made by high-yielding debt is the same as that made by high-yielding equities: more money now, less principal later.
  • The difference is that while the equity prices trend upward because companies reinvest profits into their businesses, bond prices do not. If all things remain equal, bonds prices stagnate.

Which means that a portfolio of high-yield bonds will tend to shed principal, on account of its securities’ occasional bankruptcies. So, too, will option-income bond strategies, which retain all their losing investments while being forced by exercises of call options to relinquish some of their winners. For their part, high-yielding currencies naturally tend to decline in value. If they did not, they would provide free investment lunch.

Regrettably, investing is not so easy.

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