How Will Your Investment Make Money?
This article defines the basic types of investment income and which asset classes pay them.
Interest
Interest income is paid on any kind of debt instrument as compensation for loaning the investor’s principal to the borrower, or issuer. This type of income is paid by several different types of investments, listed as follows:
• Fixed-income securities, such as CDs, bonds and mortgage-backed securities (MBS). The rate of interest is usually preset and lasts until the security matures, or is called or put.
• Demand deposit accounts, such as checking, savings and money market accounts. Depositors receive interest as compensation for parking their cash in the account from the depository institution.
• Fixed annuities, which pay a set rate of interest on a tax-deferred basis until maturity.
• Seller-financed mortgages, where the seller charges an agreed-upon rate of interest on the principal that is loaned to the buyer.
• Mutual funds that invest in the above vehicles.
No form of equity pays interest of any kind. Each of these debt instruments pays a stated rate of interest. This rate is usually fixed, but can be variable depending upon the terms of the investment. The rates for demand deposit accounts usually fluctuate, according to changes in interest rates, while the rates for bonds, CDs and fixed annuity contracts usually stay constant until maturity. Interest-bearing investments are always tied to current interest rates, and cannot by nature pay rates high enough to beat inflation over time, unless they are high-risk vehicles such as junk bonds. (Don’t be fooled by the name - junk bonds may be for you if you know how to analyze them)
Most interest-bearing securities carry a rating, such as AAA or BB, assigned by one of the major rating agencies. If this rating declines after a security is issued, this could be a possible indicator that the issuer will default on their obligation. A noticeable decline in revenues, profits or liquidity could be another warning sign. Of course, in many cases, these changes will result in a lower rating.
Dividends
Dividends are a form of cash compensation for equity investors. They represent the portion of the company’s earnings that are passed on to the shareholders, usually on either a monthly or quarterly basis. Dividend income is similar to interest income in that it is usually paid at a stated rate for a set length of time. But dividends are only paid on stocks, or from mutual funds that invest in stocks. However, not all stocks pay dividends. In general, only established corporations pay dividends, while small cap enterprises usually retain their cash for future growth.
Dividends are paid on both common and preferred stocks, although the rate is usually higher on preferred stocks than common. Dividends can also be either ordinary, which are taxed as ordinary income, or qualified, which are taxed as long-term capital gains. In most cases, companies are not required to pay dividends, at least on common stock. Because dividends are a function of corporate revenue, poor cash flow or profit margins can signal an upcoming reduction or absence of dividend payments to shareholders. Dividend yields can vary, according to the type of security upon which they are paid; common stock dividends tend to fluctuate with a company’s current profitability, while preferred stock dividends are generally tied to interest rates. Because they are considered higher-risk investments than bonds, the yields on preferred stocks tend to float at a rate above that of CDs or most types of bonds, except perhaps junk bonds.
Capital Gains
Capital gains represent the appreciation in the price of a security or investment from the time that it was purchased. These gains can be either long or short term, depending upon whether the instrument sold was held for more than a year. Both equity and fixed-income securities can post gains (or losses). However, while fixed income securities can appreciate in price in the secondary market, they are designed primarily to pay current interest or dividends while stocks and real estate provide the bulk of their reward to investors in the form of capital gains. Historically, the gains posted by stocks and real estate are the only investment returns that have outpaced inflation over time, which is one of their chief advantages. Of course, the markets move in two directions, and any security or investment capable of posting a gain can also result in a loss. Equities rise and fall with the overall markets as well as from corporate performance.
Total Return
Of course, many types of investments provide more than one type of investment return. Common stocks can provide both dividends and capital gains. Fixed-income securities can also provide capital gains in addition to interest or dividend income. Total return is calculated by adding capital gains (or subtracting capital losses) to dividend or interest income and factoring in any tax savings.
Conclusion
Different types of investments post different types of returns. Some pay income in the form of interest or dividends, while others offer the potential for capital appreciation. Still others offer tax advantages in addition to current income or capital gains. All of these factors together comprise the total return of an investment.
Source: Investopedia
September 13th, 2009 at 10:25 pm
Thank you much for that good piece of text.
February 15th, 2010 at 10:47 am
This is a good approach to what, for some, may be a controversial topic. Very well though out post. - I’m not afraid to die. I just don’t want to be there when it happens. - Woody Allen Born 1935
February 18th, 2010 at 5:00 am
Then again, the opposite could be true. - I
February 21st, 2010 at 2:29 pm
I just buy corporate bond funds with intermediate target maturities. Corporate bonds are still paying a little bit, and Corporate America is fairly healthy right now. Whether they can keep the bottom line stable with a constantly shrinking customer base (thanks to a shrinking number of gainfully employed people) is a legitimate question, but it’s a stretch to say they can’t service their debt of the next seven years if they are investment-grade now. Even though inflation is a near certainty, we still don’t know when it’s coming, and there’s no point, in my opinion, bailing now when it could be two or three years. In any event, the inflation is much more likely to be Jimmy Carter-style vs. Zimbabwe-style, and Carter-style inflation won’t drive intermediate term bonds down in price anywhere nearly as bad as what you’d call a bubble asset, like a dot-bomb stock or a house out in the Arizona desert. As for treasuries, there’s not much point in investing in them now even without a bubble scare. The returns are so pitiful, you might as well hide the cash in your mattress. TIPS are a fine concept, but you had better have your TIPS in some kind of tax-advantaged account, since the nominal return is taxable. Since the rate on them is essentially zero above inflation, when inflation picks up your economic loss will be the nominal return times your tax rate.
February 21st, 2010 at 3:31 pm
My advice to people with bond portfolios right now is to sell the bonds that are at a profit to take the profits off the table (anticipating rising rates in the near future) and hold the bonds that are at a loss for the most part. In regards to the rest of their retirement portfolio, i recommend a diversified market driven portfolio of bond and stock mutual funds and etf’s (managed by a professional money manager) and using income annuities to meet your basic cost of living that the income from the bonds doesnt meet. if your interested in leaving a legacy, you might want to consider permanent life insurance as well.
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