Income is to yield, as eggs are to an omelette – they’re an essential ingredient but not quite the same thing. Income from a portfolio may not equal the yield, and the distribution that investors actually receive may differ again.
This Q&A will help you to understand the differences if you’re considering an investment in an income fund.
What is income?
In the investment world, the most common and useful definition of income is natural income.
Natural income is the cashflow generated by a set of assets. This is the cash produced by securities in a portfolio, whether that’s dividends from equities, coupons from bonds, rental income from real estate, or net cashflow from infrastructure projects.
Natural income does not include cash generated from selling assets. If assets in a portfolio are a factory, then income can be thought of as the factory’s output.
If you dismantle the factory, then output falls. In the same way, while selling assets may create a one-off gain, any future income is diminished.
What is yield?
Yield is a measure of return. While there are different definitions of yield, current yield (also called running yield) is particularly helpful when looking at income investing.
The current yield is the income generated, measured as a proportion of the price of an asset, and so is an easy way to compare investments.
When analysing ‘real’ assets like real estate and infrastructure, the costs and fees of managing the asset can vary from project to project and can have a significant effect on yield, so they should not be ignored. For financial securities like equities and bonds, these costs tend to be small and comparable.
What is the distribution from an income fund?
An investor in the distribution share classes of an income fund receives a regular payment. This payment comes from either the income generated by the fund’s assets, the realised gains on those assets, or from the asset’s capital – or a combination of the three.
Distributions may be pre-specified, so investors know beforehand what they will receive, or they can vary depending on the performance of the underlying assets.
It’s is important that investors know what the distribution is based on, as the different approaches have benefits and drawbacks.
Don’t fall into the ‘yield trap’
As we mentioned, the yield on an investment is the income generated, as a proportion of the asset’s current price.
What can happen, however, is that if the income generated by the fund’s assets falls, the distribution that is paid to investors may include natural income and capital.
While paying out distributions from capital can ensure the income level is maintained, it can decrease the potential for future income generation, due to the fund assets being reduced.
The problem comes when fund assets underperform, and the investment manager must sell assets to deliver the promised distribution. If markets go through a period of prolonged weakness, this could lead to a downward spiral, where there are fewer and fewer assets to generate the required distribution.
More assets then must be sold to make up the shortfall, and so on, until the fund’s capital base has shrunk so much it may never recover.
For investors who depend on income to finance their retirement, it’s important that they understand how their income distributions are paid.
How to approach income investing
With income investing, it can be useful to think about optimising your distribution, rather than maximising it, by focusing on choosing the distribution approach that best suits your needs.
Funds with a lower (conservative) distribution target generally have lower capital volatility, while those with a higher (aggressive) distribution will pay out more income but the volatility of capital base can be often higher.
This article is written by Fidelity International Limited.