How To Navigate the World of Income

Too many investors are intimidated by "income investing." Either they think it's more complex than regular stock investing or they don't think it's as good as that supposed hot stock tip that could earn you triple-digit gains.

But trust me, there's no better feeling in the world than having a steady stream of cash payments hit your account every month or every quarter.

Personally, money in my pocket always meant more than a potential triple-digit winner that required "things to work out right."

Today, I want to talk a bit about income investing. I believe it's truly one of the best ways to grow your wealth over time. And if you're in or near your retirement, income investing is definitely for you.

Most folks think that income investing means buying stocks that pay dividends like Coca-Cola (KO) or even utility stocks. But the income world is much larger than that. There are all kinds of different income-producing assets that folks should be taking advantage of.

With that said, I'm going to talk about four different types of income-producing assets today. I will walk you through the basics of each of these different income vehicles and how they can help your portfolio.

Let's start with...

Real Estate Investment Trusts (REITs)

Real estate investment trusts (REITs) invest in real estate and pass the rental income on to shareholders.

REITs are not the same as a company that manages real estate. They have a unique corporate structure designed to closely simulate a direct investment in real estate. To qualify as a REIT, a company has to fulfill several requirements. For our purposes, these two are the most important...

  • The company must derive 95% of its income from dividends, interest, and property income.
  • The company must pay at least 90% of its income to shareholders as dividends. 

In exchange for meeting these requirements, the company doesn't have to pay corporate taxes on most of its earnings.

In this sense, buying shares of a REIT entitles you to virtually the same income as if you were able to buy the properties and hire a property manager... except you get to avoid the headache of operating a property.

To think about REITs, you have to think like a landlord... How are rental rates trending? What's the vacancy rate? Are property prices rising?

REITs come in all shapes and sizes: residential, retail spaces, office spaces, industrial, and campus housing, for instance.

They also exist in assets that you might not consider real estate at first glance, like mortgage REITs, which hold a portfolio of mortgage-backed securities. As the borrowers who took out these loans pay down their debt, the payments get passed through the REIT back to the shareholders.

How to earn income: The income from a REIT comes in the form of dividends. Like a stock, this is usually paid on a quarterly basis.

But judging the safety of the income from a REIT is a bit different. Rather than focusing on earnings, a REIT is better judged by its funds from operation (commonly known as FFO). FFO shows how much money a REIT earns from its rental fees.

Master Limited Partnerships (MLPs)

Master limited partnerships or MLPs are similar to REITs. They have a favorable tax structure that gives investors nearly direct access to less-liquid but income-generating assets.

In the case of MLPs, the IRS has a list of "qualifying assets" that are allowed. The most common items are related to energy and natural resources like oil pipelines, refinery services, and natural gas storage.

MLPs also pay little to no corporate taxes as a reward for passing income on to shareholders.

Typically, MLPs work like a toll road. Pipelines transport a commodity for a fixed fee without worrying about production rates or commodity prices. It's a simple way for an asset to generate cash.

How to earn income: MLPs typically pay income in the form of quarterly distributions. Eyeing up economic activity and competition surrounding the particular assets will give you a good idea of where income levels could be headed. For instance, with the natural gas boom in the U.S., the income derived from natural gas pipelines has risen.

When judging the safety of MLP income, cash flow trumps earnings. In particular, MLPs report a statistic called "distributable cash flow." This is the amount of cash flow that the partnership can pay to shareholders after paying to maintain the equipment.

Municipal Bonds

Just like a corporate bond, a municipal bond's asset is a loan. But in this case, it goes to a municipality – either a local or state government.

Unlike corporations, municipalities have the power to tax. That changes their risk profile. The historical default rate on municipal bonds is virtually nil.

Some municipal bonds are considered general obligation bonds, meaning the city owes on the bonds no matter what. In these cases, the true asset is a loan secured by the municipality's power to tax.

Others are revenue bonds tied to a specific asset. For example, bonds can be issued to build a new baseball stadium. Then the revenue the stadium generates goes toward paying off the bonds. These bonds can be considered riskier, since bondholders are at the stadium's mercy. But in the event of a default, bondholders would still be able to recoup some of the losses, unlike shareholders in corporations.

How to earn income: Muni bonds have nearly identical features to corporate bonds. Only one calculation is different... and it's what makes municipal bonds more attractive.

Most municipal bonds are tax-exempt... At a minimum, you don't have to pay federal income tax on the income you receive. And if you hold municipal bonds issued in the state where you live, you don't have to pay state taxes on them either, making munis a great asset for creating wealth.

This gives rise to a concept called "tax-equivalent yield."

Imagine you have $1,000 to invest and the choice of a corporate bond or a municipal bond. Let's say the corporate bond pays 6%, and the municipal bond pays 5%. It looks like the corporate bond is more attractive. But to correctly compare them, you need to consider the tax implications...

That's why you calculate the tax-equivalent yield. If your tax rate is 28%, the municipal bond pays the same as a corporate bond yielding 6.9%, so the muni actually offers the higher yield.

The formula is: (municipal yield) / (1 – tax rate).

Preferred Stock

Preferreds are considered hybrid securities since they have some characteristics of bonds – for example, they deliver fixed-income payments to shareholders – and some characteristics of stocks.

Preferred shares are a form of debt that trade on public stock exchanges. They are highly liquid securities and can be easily bought and sold, just like common stock.

But preferreds also represent bond-like security. Should bankruptcy happen, preferred-stock shareholders have claims against the assets of the companies – like a bond. Although their claim is a lower priority than those of traditional bondholders... it's a greater measure of security than common-stock shareholders have. (Their claims come at the end of the line.) However, most preferred shareholders lack voting rights, something common-stock shareholders do enjoy.

You can find prices for preferred shares on free sites like Yahoo Finance. You always want to compare the current price to the callable price. If a company can buy back its shares for $25 (the callable price), you wouldn't want to pay much more than $25 for them.

How to earn income: The quoted coupon yield can vary from the true yield, which is calculated as yield-to-maturity. For preferreds, yield-to-worst is a similar measure. When preferreds are callable, they typically have a provision that prevents them from being called until a specific date.

So while a preferred may pay a 6% dividend on shares it issued for $20, an investor can earn a different yield since the price can fluctuate. In the case of a preferred share, yield-to-worst is the most useful way to calculate what you can truly earn. The yield-to-worst considers the current price, the dividend payments, and the possibility that the company will call the shares at the first chance they get.

Companies don't always call their preferreds right away. It typically depends on if they have the cash or what prevailing interest rates are. But this yield-to-worst provides a "worst-case scenario" estimate of what sort of yield we can expect.

There are many ways to earn income rather than just corporate bonds or dividend-paying stocks. And you should be taking advantage of some of these strategies.

I believe a retirement crisis is coming. And when it's here, you'll want safe, steady income protecting your nest egg.

Last week, I released an urgent warning for our readers (especially for those of you at or approaching retirement age).

I explained the crisis I see brewing in our country's financial system, with more calm and clarity than anyone you'll see on the news. And I showed exactly what to do about it... the exact steps to take with your money right now to protect yourself.

Click here to watch now.

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Here's to our health, wealth, and a great retirement,

Dr. David Eifrig and the Health & Wealth Bulletin Research Team
June 30, 2021