The income investing strategy has become a popular choice among investors. Focused on making investments that pay dividends, these investors are less interested in maximizing growth and more interested in earning passive income.
When a business generates positive free cash flow, most companies that don’t pay dividends reinvest their excess cash back into the business to reach higher levels of growth. By contrast, high-yield dividend stocks return much of this value to investors by way of dividends. Firmly established companies with less room for explosive growth but a solid customer base often reward investors with predictably generous dividends.
However, blue-chip dividend stocks aren’t the only high-yield investments you’re able to tap into. In fact, there are four high-yield, safe dividend and other income investments that have become overwhelmingly popular in the investing community.
What Are High-Yield Investments?
Most high-yield investments are riskier investments that provide a higher reward than the average across the market. Some common high-risk, high-reward investment instruments include:
- Junk Bonds. Junk bonds are high-risk, high-yield securities that are issued by companies in a rush to raise money. These bonds pay higher interest rates than U.S. Treasury bonds, creating the high yield investors are looking for. However, they also pose significant risk of default, which can lead to losses.
- Venture Capital. Venture capitalists invest in companies before they really have anything to show for their work. For example, the investors on the popular television show “Shark Tank” are venture capitalists. While investing in companies in early stages poses significant risks, when these companies do succeed, the rewards are compelling.
- Foreign Emerging Markets. Foreign emerging markets like China and Brazil offer opportunities to tap into the growth of a budding economy. However, growing economies have hiccups, and when these hiccups happen, significant losses may result.
While most high-yield investment instruments are stocks, there are areas on and off the stock market that offer high-yield, safe dividends and other forms of ongoing investment income.
Pro tip: You can earn a free share of stock (up to $200 value) when you open a new trading account from Robinhood. With Robinhood, you can customize your portfolio with stocks and ETFs, plus you can invest in fractional shares.
Types of High-Yield, Safe Income Investments
Perhaps you’re not interested in taking undue risks on small companies with weak balance sheets. Neither are you looking forward to investing in shaky emerging markets. If you want high-yield options that offer safe income rather than high risk, the following investment options fit that bill:
1. Quality Dividend Stocks
Companies in these sectors have products that consumers need to live their day-to-day lives. As a result, these companies don’t have to invest as much of their free cash flow into growth because growth is highly predictable and not dependent on continued innovation. So, the excess free cash flow is converted into dividend payments.
When looking for safe dividends, look in these sectors for blue-chip stocks based on the following metrics:
The dividend yield is calculated by dividing the annual dividend offered by the share price. For example, if a stock pays a $1 dividend per year and the share price is $10, the dividend yield for the stock is 10%.
The higher the dividend yield offered, the higher your dividend payments are as a percentage of your principal investment. Dividend investors look for stocks that provide safe access to the highest dividend yields in their respective sectors. Essentially, these investors are looking for stocks that provide stable growth, little risk of loss, and reliable dividend payments.
Dividend Payout Ratio
Dividend payout ratio defines the percentage of free cash flow publicly traded companies share with their investors. It compares the amount of dividends paid to the net income generated over a time period.
For example, if a company generates $10 million dollars in net income per year and pays a $5 million dollar annual dividend to its investors, the company’s dividend payout ratio is 50%, meaning 50% of its net profit is returned to investors as dividend payments.
When your goal is to generate income, you don’t want to invest in companies with low dividend payout ratios, but you also want to keep the dangers of high dividend payout ratios in mind as well.
If companies don’t retain enough of their earnings, they could fall victim to economic headwinds. Moreover, some of the sectors that pay the highest dividends require at least some investments in maintaining infrastructure, such as pipelines or power grids. So, companies that pay exceptionally high dividend payout ratios now may have to enact dividend cuts in the future and could experience significant drops in share prices if enough free cash flow isn’t held back to get through the hard times.
As a general rule of thumb, dividend investors should look for dividend payout ratios from 35% to 70%, maintaining a level of caution as payout ratios near either end of that range.
Your goal as an income investor is to access as much income through the stock market as possible, but you don’t want to lose money in the process. In some cases, stocks that are great for dividend income are experiencing stagnant valuations, or worse, declines.
Even when practicing the dividend investing strategy, you’ll want to pay attention to stock performance. Sure, higher yields often means slower growth, but you want the growth of stocks you invest in to be on par with their industry.
To make sure you’re making the right investment decisions, look into the performance of the stock over the last year, and compare that performance to growth across the sector in the same period. If you find that the stock you’re interested in is underperforming compared to its peers, it’s time to go back to the drawing board and look for other opportunities. With enough research, you’ll find stocks that outperform their peers while paying compelling dividends.
A strong dividend stock is one that’s experiencing revenue and earnings growth and has made an art of balancing its dividend payout ratio. These stocks have a strong track record of dividend increases over several consecutive years.
Before investing in a dividend stock, look into the company’s dividend payment history. It is best to look over the past three or four years. What you’re looking for is companies that have had no dividend cuts and have seen consistent increases in their dividend payments on a year-over-year basis.
Keep in mind while you research that you can give companies some slack for the year 2020. The coronavirus pandemic shook the global economy and led to decreasing dividends and valuations marketwide, even on some of the strongest blue-chip, reliable dividend stocks.
Pricing is important no matter what you’re purchasing, whether it be a candy bar, a car, or a share of stock. Any time you invest in a stock, you should pay close attention to valuation metrics to make sure that you’re getting a fair deal.
Two of the most important valuation metrics to consider include:
- Price-to-Earnings (P/E) Ratio. The P/E ratio compares the earnings per share, or EPS, to the share price of the stock. High P/E ratios suggest that you’re overpaying while low P/E ratios suggest that you’re getting a discount. So, you’ll want to invest in stocks with lower P/E ratios than others in their sector.
- Price-to-Sales Ratio (P/S Ratio). The P/S ratio compares the revenue the company generated over the last year to the price of a single share of stock. As with the P/E ratio, you’ll want to invest in stocks that offer P/S ratios that are at par with or below the sector average.
Pro tip: Before you add any stocks to your portfolio, make sure you’re choosing the best possible companies. Stock screeners like Stock Rover can help you narrow down the choices to companies that meet your individual requirements. Learn more about our favorite stock screeners.
2. Real Estate Investment Trusts (REITs)
A real estate investment trust, or REIT, is a company that owns income-producing real estate. In most cases, these companies also operate the real-estate properties they own. REITs pool money from multiple investors to cover the cost of purchasing new real estate, maintenance, and management.
In return for their investments, the investors in REITs enjoy their share of the profits generated from the rental of these properties.
Not only are REITs compelling income investments, the most successful REITs also offer returns that often beat the average across the overall market. However, like stocks, all REITs aren’t created equal. When looking for opportunities in the space, consider the following:
High Occupancy Rates
When investing in REITs, your return on investment is directly tied to occupancy rates. If there aren’t enough consumers renting the properties owned by the trust, there won’t be any profits to share with its investors.
Moreover, real estate with high occupancy rates gives the owner the ability to increase rent, ultimately increasing revenues, profits, and return on investment for all involved. So, before diving into any REIT, look into occupancy rates, keeping in mind that the higher the rate, the better.
REIT Value Growth
REITs, like any other company, will see valuation growth if the company does well in terms of increasing revenues and profits. Before investing in any REIT, look at the value growth — or lack thereof — seen over the past three to five years.
Compare the growth in the share price to the average among REITs over the same time period. If the value of a REIT you’re considering isn’t growing at par with the industry, it’s time to walk away and look for other options.
Dividends are the name of the game in income investing. Like dividend stocks, REITs will retain some of their profits as a means to fund operations and increase growth, often through the purchase of new real estate. Another portion of profits will be sent to investors in the form of dividend payments.
So, before you invest in a REIT, look into the dividend growth experienced over the past three or four years, specifically looking for consistent growth in dividend payments year over year as well as a lack of dividend cuts over the entire three- to four-year period.
No matter what you’re investing in, you want to make sure the price is right.
Using the same P/E and P/S valuation metrics described above, see how the REIT you’re interested in compares to the overall market. On average, the P/E ratio across REITs is about 20 and the average P/S ratio comes in at about 8.68, according to CSI Markets. Like with dividend stocks, REITs with higher-than-average ratios compared to their sector may be overvalued.
3. Income-Focused Exchange-Traded Funds (ETFs) and Mutual Funds
Exchange traded funds (ETFs) and mutual funds are investments centered around diversification. These funds use assets pooled from many investors to purchase a variety of stocks in order to achieve the investment objectives set forth in their prospectus.
There are a wide range of ETFs and mutual funds designed around various investing strategies, including the income investing strategy. Income-focused funds specifically focus on generating high yields through income investments.
When looking for income-focused ETFs and mutual funds, you’ll want to pay attention to the following:
Average Annual Growth Rate
Keep in mind that if your goal is to generate high yields through the process of income investing, you’re going to have to give up some growth. So, income-focused ETFs and mutual funds won’t be the highest growth funds on the market.
Nonetheless, valuation growth is important, regardless of the investing strategy you employ. So, before investing in any ETF or mutual fund, look into the fund’s performance over the past five years. If valuations faltered in this period, there may be a cause for concern.
Again, the COVID-19 pandemic was a painful time for all, so you might give some slack when it comes to growth rate in the year 2020.
Investing in ETFs and mutual funds comes with expenses. The vast majority of ETFs are passively managed, while the vast majority of mutual funds are actively managed. As a result, costs are generally lower on ETFs than mutual funds.
Regardless of which option you choose, it’s important to keep a close eye on the expense ratio associated with the fund. The higher the expense ratio, the lower your overall returns. According to the Wall Street Journal, the average ETF expense ratio is 0.44%. According to The Balance, the average mutual fund expense ratio ranges from 0.6% to 1.14%. You’ll want to stay at or below these rates when investing in these types of funds.
When stocks held in the ETF or mutual fund make dividend payments, those payments are divided and paid out to investors who hold shares in the fund. As a result, these funds will come with their own dividend yields.
As is the case with dividend stocks, when investing in income-focused funds, you’ll want to make sure that the dividend yields offered are among the best in the industry.
Although past performance isn’t always indicative of future performance, it does serve as a strong gauge of what to expect from an investment moving forward.
Look into the dividend payments made over the past three to four years. As is the case with dividend stocks and REITs, you’ll be looking for an absence of dividend cuts and consistent dividend increases on a year-over-year basis. Once again you might offer a bit of understanding if dividends have faltered in 2020 as a result of the COVID-19 pandemic.
4. Real Estate
Finally, direct real estate investments are common among income investors for two reasons:
- Income. By purchasing a quality piece of real estate, you’ll have the ability to rent it out, generating monthly income. Moreover, as inflation continues, rental values increase, offering up an all-but-guaranteed way to ensure increasing income over the term of the investment.
- Value Growth. Historically, real estate prices have grown pretty consistently. As a result, a rental property could be purchased and rented out for decades. When the owner retires, they’re generally able to sell the property for much more than they paid to purchase it, not only enjoying the income throughout ownership but enjoying compelling returns at the end of the investment.
When looking for solid real estate investments, you should consider the following:
Location, Location, Location
The location of your real property will be a primary determining factor when it comes to the amount of rent you’ll be able to charge for that property. For example, an apartment in a big city will be far more expensive to purchase than a rural home, but the apartment in the city will likely be easier to rent out and demand a higher monthly rent, resulting in a larger income.
The location of your real estate will determine the price you can charge, how hard it will be to rent the property out, the taxes you will pay, and the rules you’ll be required to follow as a landlord, making location one of the most important factors in a decision to invest in real estate.
State of the Property
Buying a turnkey rental home or office through a company like Roofstock may seem ideal, but the cost in doing so is much higher than buying a home or office that needs work. As a result, many income investors that look to real estate as an investment vehicle buy fixer-uppers.
Before buying a fixer-upper property, it’s important that you make sure you know what you’re in for. What caused the damage? Was there a leak, termites, wind damage? Each of these will come with their own implications and costs associated with repairs.
Before making an offer on a piece of real estate that you plan on renovating and using as a rental, have the home inspected for mold and termites. Moreover, do your research so that you have a thorough understanding of the cost of the renovation. This way, you won’t find yourself as the sad new owner of a money pit.
Vacancies in the Area
Before you buy real estate that you plan on using as a rental property, take time to look into vacancies in the area. If there are several vacancies for the same type of property you plan on buying, you’ll have a difficult time renting yours out without drastically undercutting the average price of the property, which not only reduces your income, but invites less-than-desirable tenants.
Before making an offer, look for vacancies in the area. If vacancy rates are high, pass on the property and look for opportunities to buy real estate somewhere else where it will be easier to generate an income.
Pro tip: Websites like Roofstock p
High-yield income investments are an exciting idea. Not only will you earn money from the growth in valuations of your investments, you’ll benefit from relatively predictable income when the right decisions are made.
However, as with any other investment, high-yield investments aren’t created equal. Success with this investing model requires a commitment to research and a willingness to adjust your portfolio from time to time. Nonetheless, with a bit of research and persistence, you’ll have all you need to be a successful high-yield dividend investor.