There are several ways to incorporate income-generating assets into your investments, including bonds, covered call strategies and dividends from equity investments – all of which can be accessed via ETFs.
1. Access Fixed Income Through Bonds
Bonds are a common form of fixed income which help investors generate risk-adjusted returns.
They are essentially a form of debt issued by governments to help finance policies or companies to fund business activities. In return for providing a government or company with upfront capital, investors earn interest at differing rates depending on the quality of the bonds (see chart below). The higher risk the bond is, the more potential yield is earned. The US has the largest bond market in the world, and even the biggest household names such as Apple, Microsoft, Disney, and Berkshire Hathaway issue bonds.
Unlike shares which are traded on an exchange, the bond market is referred to as ‘over the counter’, meaning bonds can be traded anywhere a buyer and seller can make a deal. As such, some bond markets can be difficult for investors to access. ETFs can provide investors with the opportunity to gain exposure to these markets through a simple trade.
There are three primary types of bonds; government bonds (also called treasuries), investment grade bonds and high yield bonds.
- Government bonds are commonly considered the least risky and can offer modest returns.
- Investment grade corporate bonds are deemed to be high quality by rating agencies, so are generally seen as a medium risk option with relatively higher yields than government bonds.
- High yield corporate bonds offer the highest potential yield but are usually the riskiest as deemed by ratings agencies.
2. Take the Complexity out of Covered Calls
Covered calls are generally considered a sophisticated investment strategy, reserved for brokers or other professional traders. However, ETFs have made this income-generating investment approach far more accessible for any investor.
In short, covered call ETFs are an options-based strategy which work by holding an underlying index – the S&P/ASX 200, S&P 500 or Nasdaq 100, for example – then making a ‘call’ on what the value of the underlying index will be after a specified amount of time has lapsed. For making this call, a premium is earned, which is how income is generated.
As shown in the image below, covered call ETFs can help generate income while markets are more volatile because it is harder to predict what the value of the underlying index will be, therefore, a higher premium is earned. If markets are steadier or on the rise, premiums may reduce, and therefore covered call investors miss out on the market upside. However, dividends from the stocks in the underlying index can help smooth out income potential.
3. Maximising Exposure to Dividends
Dividends are arguably the most well-known way to generate a passive income from investing – particularly in Australia. Generally, a company will calculate how much it will pay to shareholders in dividends by the amount of profit they make and then how much they need to keep the business growing. The remainder can be paid out as a dividend. Dividends are generated on a per share basis, meaning the more shares in a company you hold, the more dividends you get.
To generate portfolio income from dividends, it is important to select companies which are likely to pay up. However, the probability of producing adequate income by choosing individual stocks is slim compared to investing in a high dividend yield ETF.
High dividend yield ETFs use strict rules to identify businesses in a given index – such as the S&P/ASX 200 or S&P 500 – which are high yielding and, as a bonus risk mitigation could also experience low volatility. Often this means the stocks included in a high yield ETF are vastly different to the broader index, as shown in the chart below. Therefore, these ETFs can offer an element of diversification as well as enhancing a portfolio’s income potential.
Creating an Income-Generating Portfolio Doesn’t Have to be Complicated
The amount and type of income needed in a portfolio will differ from person to person, but no matter your investment goals it is worth considering how you can gain exposure to these kinds of assets. Income investing can offer an element of stability to a portfolio, however, it is also important to note the potential risks of fixed income, covered calls and high yield ETFs before making an investment, including market, credit and interest rate risks. Due to their transparent nature, ETFs can be an accessible solution to help create a well-diversified, income-generating portfolio.
