Take care of your passive income

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Many investors see income investing as the key for living a life of leisure while still keeping the money or “passive income” rolling in. But income investing is far from passive, and without the right advice and planning, unsuspecting investors and retirees could soon find themselves depleting their capital base rather than enjoying the fruits of their labour, notes Citadel Advisory Partner Riaan Campbell.

“The primary consideration for an income-focused investment strategy is its ability to keep up with inflation. First prize is being able to draw only the income from your investments without having to sell shares or property, thus preserving your capital base. So ideally when managing these assets, you need to create income streams that outperform inflation, as well as generate capital growth.”

“This means, however, that income investing takes skill, time and dedication – as a client recently said to us, ‘There is no such thing as passive income.’”

According to Campbell, there are essentially three basic investment options available to income investors, and each carries risk as well as the potential for reward. These are:

1.Dividends

Many investors rely on dividends from companies in which they own shares as a source of income. However, not all companies are alike, and investors should be aware that consistent dividend payments are a function of the quality of a company’s earnings.

“Companies which consistently pay dividends are found mostly in less cyclical sectors of the economy, such as consumer staples, including food, alcohol and tobacco, as well as clothing, pharmaceuticals and the insurance sector,” he says.

Examples of global shares with these traits include Nestlé, Johnson & Johnson, Siemens, Coca-Cola and Procter & Gamble, in addition to local counters Shoprite, Sanlam, FirstRand and Santam.

Mining and commodity companies tend to be more cyclical in nature, and fall short of the definition of consistent dividend payers since they have no control over the movement of commodity prices.

“That said, don’t underestimate the potential ‘surprise bonanza’ on the upside when the commodity cycle turns in investors’ favour,” remarks Campbell.

2.Rental income

With rentals escalating, real estate values increasing, and healthy demand among tenants, collecting your income through rental from direct property investments can be very rewarding.

“However, the property sector can be highly challenging at times. Economic downturns, changes in trends and problems with tenants can turn your dream rental property investment upside down,” he warns.

“As a property investor recently remarked, ‘Stay close to your tenants and keep a personal hand on the property.’”

The reward for choosing to make a riskier direct investment is a higher yield relative to listed property in the form of Real Estate Income Trusts (REITS). However, income from listed property offers greater revenue diversification, requires less direct involvement and spreads investment risk both geographically and between different sectors in the economy.

Additionally, tax on your rental income is unavoidable, and you will also need to consider the effect that adding professional management fees to the mix might have on your investment outcomes.

3.Fixed income

Fixed income securities and money market instruments offer extremely attractive interest rates from time to time, normally associated with periods of higher inflation. However, that higher inflation simultaneously places your principal capital at risk of losing its real value or purchasing power over time (with the exception of inflation-linked bonds).

Combined with the fact that your investment income will be taxable, fixed income assets can therefore lose their attractiveness as a long-term investment when compared with growth assets such as shares and property.

“Corporate bonds represent another attractive option. Moreover, they trade at higher yields than equivalent maturity government bonds,” Campbell suggests.

“However, it is important to note that the higher yield is necessary to compensate investors for taking on additional credit risk. The lower the credit rating on a company’s debt, the higher the yield should be to compensate investors for the risk of potential default.”

“Ultimately, with the number of choices available, it is crucial to seek sound advice on something as important as securing your income if you are to manage your investments successfully. Additionally, proper tax planning and advice when creating income-producing assets could ensure you take advantage of the options available to you to reduce your tax bill.”