The great investment strategies: income investing

Of all the strategies, income investing is in the midst of a great existential crisis, but it is also arguably the oldest and historically most reliable strategy for securing a steady income in retirement.

After yet another house move a few years ago, I found my old savings book – the one with the reassuring smooth plastic cover and the deposit stamps from the village Post Office. The astonishing thing is that an instant access savings account opened in 1979 paid out an annual interest rate of 12% on cash deposits.

Most income investors will regard those days with misty eyes. The simple fact is that with near-zero interest rates on cash, a subsequent squeeze on all types of yield-bearing investments, and a rapidly retiring population that needs income, rather than growth from their investments, it is becoming harder and harder to deploy an effective income strategy. Nevertheless, it is arguably the oldest strategy in our series, and with its combination of relative simplicity and basic objectives, income investing is still worth investigating.

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It seems strange to modern sensibilities, but until the 1920s income investing was the dominant strategy in financial markets. While this seems odd considering that joint-stock companies had been around for nearly 300 years at that point, there are sound historical reasons for this.

The impact of the war and gold

The reason income investing became so dominant is a story of war and the invention of a consolidated national debt.

Although Britain has had a national debt since the 1680s, the real spur to widespread debt ownership was due to the astronomical cost of the Napoleonic Wars. Financial innovation helped Britain to decisively win the war with Napoleon by allowing it to build up a war machine, as well as subsidising its allies to continue the fight. By the end of war, the British National Debt was £1 billion, or 200% of GDP at the time. The sheer volume of issued debt guaranteed that a wider section of society would be able to acquire a perpetual fixed income of 3% per annum. The last of the Consols (short for consolidated debt) were finally redeemed by the British government in 2015.

With government bonds now in wide circulation, the next spur for income investing was the price stability. In the 19th century, new manufacturing techniques brought down the price of basic goods ever lower, increasing the buying power of the emerging middle class who could then afford spare funds to invest for income. In addition, the emergence of the gold standard in 1870, which tied currencies to the price and quantity of gold, meant unprecedentedly stable prices until the outbreak of the First World War. In such an environment, income investing brought steady, stable returns without the need to worry about inflation.

How has income investing changed?

That situation lasted largely until the cataclysm of the First World War. The war cost the British Exchequer an average of £7 million (£350 million at today’s price) a day to prosecute. The only way to finance this was to abandon the gold standard and deficit finance the war effort by tapping loans from America and other neutral powers. The resulting inflation meant investors were forced to look for alternatives to fixed-income investments, which is why the stock market, particularly in America, started to take off. Paradoxically, many money managers were very slow to change their outlook. Star economist John Maynard Keynes, whom we profile in the Value part of this series, noted that most stuck rigidly to bonds or property investments at time when inflation was eroding the real value of both.

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Where to find income now?

The stark fact for income investors these days is that to be able generate anywhere near the 6% a year that a simple cash ISA would have paid out in 2008, an investor must allocate an average of 67% of the same sum of cash to higher-yielding shares, funds, or bonds. Even if this were practical for most, the unintended effect is that investors must bear a greater volatility risk in their underlying investments for far longer than any previous generation.

The other problem is that low interest rates also reduce the incentives for companies to maintain higher dividend ratios. Recent examples of this include income favourites such as pharmaceuticals giant GlaxoSmithKline (LSE:GSK), which is cutting its dividend payout ratio to 3% from over 5%. Admittedly, Glaxo has its share of problems – not least a highly aggressive activist investor on board, plus an awkward business model that combines high-end drug research with selling toothpaste (although it has offloaded Lucozade to the Japanese company Suntory) - but it does leave income investors with a shrinking set of options, most of which consist of traditionally higher-yielding finance and insurance shares.

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Another option might be to look seriously at bond income funds, or less commonly, at individual bonds for a steady stream of coupon payments. Individual bonds have never really taken off in the UK, despite the best efforts of the London Stock Exchange’s Order book for Retail Bonds (ORB) market to give access to individual instruments for retail investors.  

Rethinking income strategy

One approach to this problem might be to change your own investing mindset and look again at whole asset classes, rather than individual equities as a source of income, by actively buying and selling holdings to create a stream of income. The key is to make a very clear distinction between cyclical shares such as miners, house-builders, and airlines, where earnings are tied to the underlying business cycle, and true defensives such as telecoms, tobacco, consumer durables and pharmaceuticals.

Splitting your capital between dividend-paying defensive sectors and actively selling down holdings that are showing good profits would take advantage of the natural tendency of defensives to outperform over the long term. The market routinely underestimates how much life is left in industries that are supposedly ex-growth, while at the same time applying a risk discount in case some defensives are not as robust as they appear.

In fact, defensive outperformance is one of the few consistently provable investment patterns in the equity market. An additional benefit of actively turning defensive profits into income is a reduction in the volatility “tail risk” of keeping a large amount of capital invested, while using a narrow asset allocation to boost overall returns.