Income Investing: Bonds, Stocks, and Mixed Assets

A bond is a financial instrument that represents a loan made by an investor to an institutional borrower, such as a company or governmental body. Think of it as an IOU in which the details of the loan—amount, interest to be paid to the investor, payment schedule, and maturity date—are preset and disclosed in an active trading market.

When you purchase a bond, you, the investor, are essentially loaning money to the bond issuer for a set amount of time at a variable or fixed rate. In return, the issuer makes periodic payments and promises to repay your principal to you at maturity.

• Low volatility: Although bond prices fluctuate like most other assets, their movements tend to be much less volatile than stocks. The investor's aim often isn't to buy low and sell high, but rather, to receive income and hopefully the entire principal at the bond's maturity date. The bond's value could be less than the purchase price should the investor sell the bond instead of holding it to maturity.
• Consistency and predictability: As with any income source, it's nice to know how much you'll be paid, when you'll be paid, how long you'll be paid, and in the case of bonds, when your principal will be repaid. The disadvantage is that there is no guarantee that the principal will be paid back upon maturity, and not even a guarantee that the interest payments will be made. While this might sound discouraging, the good news is that investors can see a helpful depiction of this risk before they invest by looking up a bond's credit rating. 
• Laddering for longer-term income: Suppose you want to receive bond income for the next 10 years but might need to access some of your invested capital within that time. You can "ladder" your investments by allocating funds to bonds with different maturity periods, such as two-year, four-year, six-year, eight-year, and 10-year securities. When one bond matures, you can redeem the funds and use them for personal expenses, or you can reinvest, perhaps into another 10-year bond, which will extend your ladder.

• Higher yields often mean higher risk: Lenders typically charge higher interest on loans for borrowers with poorer credit ratings. The same holds true with bonds. The lower the issuer's credit rating, the higher the yield. But with this higher yield comes a higher risk that the borrower will default.
• Interest rate risk: Another risk inherent in bonds is that prices fluctuate along with interest rates and interest rate expectations. So, if you redeem a bond before maturity, it could be worth less than your purchase price.

Another way to potentially receive income is to hold a portfolio of stocks that have historically paid dividends. A dividend is a portion of a company's earnings distributed to shareholders in the form of cash. Dividend stocks can often provide a stream of income and have their own set of pros and cons.

What are some potential advantages?

• Price appreciation: In addition to providing income through dividends, a stock can also rise in value. This gives the investor the potential benefit of portfolio growth in addition to income.
• Income and cash flow: Stocks tend to rise and fall more quickly than bonds. So, if a dividend stock is rising, you have the choice to take dividends for income or sell some shares to generate cash flow. Of course, when pursuing an income goal, selling a dividend stock that has done well means looking for a replacement stock that will not only provide a dividend, but also offer an appealing value. If the investor sells while stocks are up, finding an attractive value proposition may be very difficult.
• Market cycle flexibility: Investors may find an opportunity during a market rally or downturn to accumulate more dividend stocks or alternately to cut down on equity exposure. Because dividend stocks can be traded intraday and are generally more liquid than bonds, they can be more flexible when it comes to managing a portfolio more intensively.

What are some risks?

• Volatility: The biggest risk is that during a correction, bear market, or economic recession, the value of an equity portfolio may decline. If this happens, some investors might decide whether to hold on to dividend stocks or reduce exposure by selling a few shares; holding more cash; or reinvesting into other stocks, bonds, or other asset classes.
• Variable dividends: There's also the risk of a company slashing or ending its dividends. In a bear market or recession, some companies may need to preserve capital or reinvest revenues toward their own expenditures. In such cases, some companies may choose to reduce, temporarily halt, or completely do away with dividends.

If bonds represent a relatively conservative approach to income investing, and dividend stocks offer a more aggressive approach, a multi-asset portfolio might represent the middle-of-the-road path for investors seeking both income and growth.

A multi-asset income approach consists of a wider and more diverse mix of dividend- and yield-targeting assets. In addition to holding bonds and dividend stocks, some investors might also consider a few other income focused assets, such as master limited partnerships (MLPs), real estate investment trusts (REITs), and others.

When it comes to time horizon, each asset might have a different maturity profile, which means you may need to manage your multi-asset portfolio more actively. Some assets might mature, like bonds, which ends at a known time. Others, like some stocks, may start out as the trendy new idea, then develop into established firms, and perhaps one day become a major participant in their industry.

What are some potential advantages?

• Growth and income: The main advantage with a multi-asset approach is that you can seek both growth and income in a way that might not be achievable with a 100% bond or dividend equity portfolio at the same level of risk. This is because a multi-asset portfolio might include a wider mix of assets, which can further diversify your total holdings. While the potential for returns may well be greater with an all-stock portfolio, the level of returns expected given the degree of risk taken in the multi-asset portfolio can be appealing. Some income investors will choose the higher returns associated with stocks, and some will choose the lower risks associated with bonds, while others will chose tempering the portfolio's volatility profile with a mix.

What are some of the risks?

• Combined risks: A portfolio containing a mix of stocks and bonds inherently comes with all the risks of stocks and bonds as described above. The hope is that the timing of the risks will be different. While this is often the case, in some instances, such as an overall economic downturn, stocks and bonds could both be in decline. Other income-focused investments such as MLPs and REITs, can be thinly traded at times and thus more difficult to liquidate, and these assets can also experience a decrease in value while stocks and bonds are declining.
• Complexity: Some other assets are complex instruments that should only be considered by experienced investors. For example, REITs are subject to the same risks as direct investments in real estate, including loss of principal and sensitivity to economic downturns.

Bonds, stocks, or multi-asset—whatever you decide to hold in your income portfolio, it's important to ensure your choices are consistent with your goals, time horizon, and risk tolerance.