practice essentials birds eye view income investing
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I n c o m e I n v e s t i n g
S & P I N D I C E S
P r a c t i c e E s s e n t i a l s ™
Income Investing 101
S&P INDICES | ™Practice Essentials
U.S. Retirement demographics and the current
low-yield environment for CDs and Money Market Funds have generated advisor interest in higher yielding investment instruments.
A Birds-Eye View of Income Investing: An
Investment Strategy with a Renewed Purpose
The U.S. Census Bureau estimates that over 78 million people – also knownas “baby boomers” – were born between 1946 and 1964. For retired “babyboomers” or those planning to retire, investing for income generation whilemitigating risk plays an important part in their investment planning. Therefore,it is not surprising that interest in income investment strategies is on the riseamong financial advisors. Financial advisors design these strategies todeliver income to clients either from the yield of a financial instrument or froma more diversified portfolio of instruments.
In this Practice Essentials whitepaper, we explore the similarities anddifferences among some of the investment choices typically used to buildincome investing solutions. This analysis goes beyond yield into the role orcontribution of income to total return. We also evaluate the diversificationpotential of this strategy, as viewed through the lens of the correlation ofhistorical returns among income producing asset classes.
The quest for yield
Since 2008, performance has suffered for some of the typical income-producing choices selected by advisors. As such, the returns on a number ofmoney market deposits, certificates of deposit and short-term treasuryinstruments are reflective of the low-interest rate and low inflation environment
seen today. This result has led more investors to consider adopting anincome investing strategy in order to access the elusive yield. This quest foryield may benefit clients as income plays a more significant role in the totalreturn of a security, fund, or portfolio.
Yield is an important concept in understanding the potential return of anincome-generating investment and, in turn, relating that potential return toother investments. For advisors, it is worth understanding the followingdistinctions between the different forms of yield associated with variousinvestment opportunities:
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For common and preferred stock, dividend yield is often quoted. Divided
yield is calculated by dividing the dividend by the stock price.
For bonds, there are several important calculated yield values:
- Yield to maturity : the overall return investors will receive basedon the price of the bond if held to maturity.
_________________ 1.Please see appendix for descriptions of investment instruments that produce yield for
income generation purposes.
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Practice Essentials | Income Investing 101
The current dividend yield of the S&P U.S.Preferred Stock Index is greater than 7%.
- Yield to worst : the return investors will receive based on theprice of the bond and the worst possible outcome, from aninvestor’s perspective, resulting from the following events:
⇒ Bond being paid off earlier than maturity due to aprior optional call provision.
⇒ Holding the bond to maturity.- Taxable equivalent yield: a comparative yield for tax-exempt
municipal bonds that relates the tax-exempt yield to the yieldrequired in order for a taxable bond to achieve the same after-taxbenefit. Please refer to S&P’s Practice Essentials paper, TaxableEquivalent Yield, for more details.
- Current yield: At times, corporate bond yields are quoted in termsof Current Yield. Current Yield is calculated by dividing the statedannual interest rate by the current price of the bond.
The Role of Income in Total Return
Common stock, preferred stock, and bonds all have different income generating
characteristics. Chart A below, depicts the income yield generated by severalasset classes, as of December 31, 2010. Yields can change dramatically overtime. Therefore, indices are used in the chart to measure these asset classes in abroad manner and to help provide transparency into the relative yields of eachasset class.
Chart 1: Dividend Yield Across Asset Classes
Yield
1.46%
7.64%
4.85%
Yield4.00%
3.66%
1.81%1.57%
Taxable
Equivalent
Yield
2.24%
Taxable
Equivalent
Yield
6.15%
0%
1%
2%
3%
4%
5%
6%
7%
8%
S&P Short Term
National AMT-Free
Municipal Bond
Index
U.S. Government
Bonds
U. S. Equi ti es S& P Hi gh Yi el d
Dividend Aristocrats
S&P International
Dividend
Opportunities Index
S&P National AMT-
Free Municipal
Bond Index
S&P U.S. Preferred
Stock Index
Source: Standard & Poor’s. Data as of December 31, 2010. Dividend Yield is used for U.S. Equities
and Preferred Stock. Yield to Maturity is used for bonds. U.S. Equities are represented by the S&P500 Index. U.S. High Yield Dividend Equities are represented by the S&P High Yield DividendAristocrats Index. U.S. Preferred Stock is represented by the S&P U.S. Preferred stock Index. U.S.Government bonds are represented by the S&P/BGCantor U.S. Treasury Bond Index. Tax-exemptmunicipal bonds are represented by the S&P National AMT-Free Municipal Bond Index. Short termtax-exempt bonds are represented by the S&P Short Term National AMT-Free Municipal Bond Index.Taxable Equivalent Yield is calculated using an assumed 35% tax rate. Charts, calculations andvalues used in this analysis are shown for illustration purposes only. An index yield can change overtime as it is calculated based on the underlying constituents of the index.
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Practice Essentials | Income Investing 101
For both stock and bond investments, dividend and interest income streamscontribute to the total return of the investment. Total return measures both thechange in price of a security and any additional cash flow holders may havereceived, including dividends or interest over a specific period of time. Totalreturn calculations do assume that the income is reinvested in the asset classbeing measured. Total return is an appropriate measure for advisors seekingboth growth (price appreciation) and income. However, for clients who need touse the income generated from the strategy, advisors must set different returnexpectations based on the impact on the portfolio of the rate of payout.
To illustrate the impact of income on total return, Table 1 below depicts thecontribution to total return of dividends and interest for differing asset classes forthe period of 12/31/2009 to 12/31/2010.
Table 1: Index Characteristics: Data through December 31, 2010
Asset ClassRepresentativeAsset Class Index
Annualized
TotalReturn
(7 years)(%)
StandardDeviation(7 Years)
(%)
YTD
Year to IncomeDate Total (Dividends
Return or Interest)(%) (%)
U.S Equities S&P 500 Index 3.85 15.5 15.06 2.28
U.S. HighS&P High Yield
YieldDividend Aristocrats
DividendIndex
5.09 16.1 16.80 4.49Equities
InternationalS&P International
High YieldDividend
DividendOpportunities Index
13.49 24.2 8.44 5.58Equities
U.S.S&P U.S. Preferred
Preferred
Stock IndexStock 3.46 22.7 14.99 8.62U.S Tax-
S&P National AMT-Exempt
Free Municipal BondMunicipal
Index3.99 5.1 2.30 4.81Bonds
U.S. ShortS&P Short TermTerm Tax-
Exempt National AMT-FreeMunicipal Municipal Bond Index
3.35% 2.1% 1.59% 4.62%Bonds
Source: Standard & Poor’s. Data as of December 31, 2010. The chart is provided for illustrativepurposes and may reflect hypothetical historical performance for some of the returns. Please see thePerformance Disclsoure at the end of this document for important information and limitations regardingthe calculation of the index as well as the use of hypothetical historical performance.
As the data above shows, annualized total return and the contribution to totalreturn of dividends and interest earned varies. The S&P indices, noted above asbenchmarks for the different types of income generating assets, were chosen fortwo reasons:
1. By construction and methodology, each attempts to measure aninvestable portion of the asset class in question.
2. Each of the indices has been licensed by a fund provider, and offeradvisors an actionable way to capture income via ETFs tracking therelevant index. For a listing of licensed funds on these indices,explained below, visit www.SPindices.com/4solutions.
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Dividend-seeking S&P indices. The case for dividend investing isstraightforward – upside potential with some downside protection. The downsideprotection comes from dividends providing a stable source of income even whenstocks may be declining in price.
S&P High Yield Dividend Aristocrats is an index measuring 50 U.S. domiciledstocks that have paid increasing dividends in each of the previous 25 years.
S&P International Dividend Opportunities is an index measuring 100 of themost liquid, high dividend yielding international common stocks or ADRs. Stocksin this index must have five years of earnings growth history and profitability. Thisindex is maintained to cap sector, country, and company weightings.
As of December 31, 2010, S&P US Preferred Stock measures 224 issues acrosseight of the ten sectors, with the bulk of holdings coming from the Financials andConsumer Discretionary sectors.
S&P International Preferred Stock measures the developed European and
Asian Markets. The index was launched in August 2010 to meet demand for aninvestable benchmark capturing non-U.S. developed markets and the high yieldsand diversification they may provide.
S&P Municipal Bond Indices
S&P High YieldDividendAristocratsmeasures 50 U.S.Stocks which
have paidincreasingdividends over thepast 25 years.
. Investment-grade municipal bonds are used bysome advisors to provide income while maintaining relatively secure principal,assuming the bonds are held to maturity. The S&P National AMT-Free MunicipalBond Indices are broad, comprehensive, market value-weighted indices designedto measure the performance of the investment-grade tax-exempt U.S. municipalbond market.
As of December 31, 2010, S&P National AMT-Free Municipal Bond Index consists of approximately 8,428 bonds, with a total market value of approximately
US$ 526.9 billion. The index consists of a broad-based national index, as well asstate-level and maturity-based municipal bond sub-indices
S&P Short-Term National AMT-Free Municipal Bond Index includes all bondsin the National index that have an effective maturity, as measured from the firstbusiness day of the month, that is greater than or equal to one month and lessthan five years.
Diversification Potential as Measured by Asset Class Correlations
In these volatile times, a diversified approach to income investing may helpreduce concentration of risk in any one asset class.
Table 2 on the following page shows the seven-year historical correlations of theasset classes previously discussed.
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S&P US Preferred Stock Index has a 0.581 correlation with the S&P 500
and a 0.262 correlation with the S&P National AMT-free Municipal Bond Index.
Table 2: Historical Asset Class Correlations Using Indices
7-YearCorrelation
S&P 500Index
S&P HighYieldDividendAristocratsIndex
S&PInternationalDividendOpportunitiesIndex
S&P U.S.PreferredStockIndex
S&PNationalAMT-FreeMunicipalBondIndex
S&PShortTermNationalAMT-FreeMunicipalBondIndex
S&P 500 Index 1.000
S&P High YieldDividendAristocratsIndex
0.853 1.000
S&PInternationalDividendOpportunitiesIndex
0.886 0.716 1.000
S&P U.S.Preferred StockIndex
0.581 0.532 0.646 1.000
S&P NationalAMT-FreeMunicipal BondIndex
0.221 0.152 0.225 0.329 1.000
S&P ShortTerm NationalAMT-FreeMunicipal BondIndex
0.027 0.113 0.026 0.262 0.769 1.000
Source: Standard & Poor’s. Data as of December 31, 2010. This chart is provided for illustrativepurposes only and may reflect hypothetical historical performance for some of the indices referenced.Please see the Performance Disclosure at the end of the document for important information andlimitations regarding the calculation of the index as well as the use of hypothetical historicalperformance.
The table above highlights interesting diversification benefits previously achievedby adding certain income-producing funds, as measured by S&P indices, totypical core holdings in a portfolio.
In conclusion, income investing, or the strategy of selecting securities or fundsbased in part on the potential income stream they may provide, may be aneffective tool for generating returns. The income of a security (a common stock,preferred share, bond, or fund) plays an important role in the total return of thatsecurity. These income strategies do not have to be overly complicated or difficultto implement in a client’s portfolio. By tracking the indices described in this paper,
an advisor can seek to leverage passively managed products exclusively or incombination with a managed approach to meet client needs for income, greaterdiversification, and growth or capital preservation potential.
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AppendixIncome Generating Assets Further Explained
Income generating assets include dividends from equity investments, interest from fixed income securities,
interest earned from certificates of deposit and income earned in real estate investing. For the purposes of thispaper, the focus is placed on income generation from equity and fixed income securities.
Income from equity ownership from dividends:
Common Stock: Also known as common shares, represents partial ownership in a company, typically withvoting rights.
o Not all companies pay dividends on common stock.o Dividend payments can fluctuate based on company earnings.o Common stock holders receive dividend payments only after any interest is paid to bondholders
and dividends are paid to preferred shareholders.
• Preferred Stock: Similar to common stock, preferred stock represents partial ownership in the company,but without the voting rights.
o Dividends for preferred stock are fixed or preset at issuance.o Preferred stock dividends are usually stated as a percentage of face value (Par) of the preferred
share.o Preferred stock dividends are paid prior to common stock dividends, but only if funds are
available.o Preferred stock holders have a higher claim on a company’s assets in the event of bankruptcy or
liquidation.o There are four common types of preferred stock:
Cumulative: These shares give their owners the right to "accumulate" dividend paymentsthat were skipped due to financial problems; if the company later resumes payingdividends, cumulative shareholders receive their missed payments first.
Non-Cumulative: These shares do not give their owners back payments for skippeddividends.
Participating: These shares may receive higher than normal dividend payments if thecompany turns a larger than expected profit.
Convertible: These shares may be converted into a specified number of shares ofcommon stock.
Income From Fixed Income Securities From Interest Payments.• In general, bonds represent a loan made by investors. In return for the loan, the bond issuer (borrower)
promises to repay the amount borrowed (principal) to the bond holders (lenders) at specific date or datesin the future (maturity). In return for borrowing the money, the bond issuer promises to pay bond holdersperiodic interest (known as a coupon) on the amount of the loan outstanding (also called par or facevalue). These payments are usually made every six months, up to and until the day the bonds are repaidin full.
o For bonds, there are three prominent variations of interest rate types:
Fixed rate bonds : Set at issuance, the interest rate on fixed rate bonds remainsunchanged throughout the life of the bond. The interest rate is usually stated as a % ofpar (Par represents 100% of the face value of the bonds). The frequency that interest ispaid is set at issuance and common frequency of interest payments are monthly,quarterly, semi-annually, and annually.
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Floating rate or adjustable rate bonds : The interest on these bonds changes periodicallybased on preset rules. Weekly, monthly, semi-annually, annually, and other schedulesfor interest rate changes are not uncommon. The interest rate on these bonds is usuallytied to a base rate or an index such as LIBOR.
Zero coupon bonds : No interest is paid on these bonds. Instead, the bonds are sold at a
discount to the face value of the debt and at maturity pay the bond holders the fullamount of the loan. The discount to par (face value) is calculated based on the yield associated with the bond. A permutation of zero coupon bonds is deferred interest bonds where all interest that would normally be paid on a periodic basis is accumulated andpaid to bond holders at maturity.
Bonds are issued by many entities, but the most common issuer types are:
• Government Bonds - issued by the U.S. Government and include Treasury Bills, Notes, Bonds, andTreasury Inflation Protection Securities. Interest received by bondholders is subject to federal taxation.
o Treasury Bills, or T-Bills are sold at a discount to Par and have a maturity range of a few days to52 weeks.
o Treasury Notes, sometimes called T-Notes, earn a fixed rate of interest every six months until
maturity. Notes are issued in terms of 2, 3, 5, 7, and 10 years.o Treasury Bonds pay a fixed rate of interest every six months until they mature. They are issued in
a term of 30 years.o Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The
principal of a TIPS increases with inflation and decreases with deflation, as measured by theConsumer Price Index. When a TIPS matures, you are paid the adjusted principal or originalprincipal, whichever is greater. TIPS pay interest twice a year, at a fixed rate. The rate is appliedto the adjusted principal; so, like the principal, interest payments rise with inflation and fall withdeflation.
• Municipal Bonds - issued by states, local governments, and political subdivisions such as school districts,or by governmental agencies and authorities for a wide variety of basic services and public purposes.Many major infrastructure, educational, housing, health care, and public utilities are financed through the
use of municipal bond proceeds. Income received from tax-exempt municipal bonds is exempt fromfederal government taxation. Please refer to the Practice Essentials paper Municipal Bonds: Back to Basics for more information.
• Corporate Bonds - issued by industrial, financial, and service companies to finance capital investmentand operating cash flow. Some bonds have a higher priority or seniority than other bonds issued by thesame company. Interest received by bondholders is taxable income.
Additional Resources
The Rieger Report Podcast: www.podcasts.standardandpoors.comS&P Indices Market Attributes®: www.marketattributes.standardandpoors.comS&P Indices Thought Leadership Center: www.SPindices.com
S&P Fixed Income Indices: www.fixedincomeindices.standardandpoors.comSolutions for Financial Advisors: www.SPindices.com/4solutions
Stay Connected
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Performance Disclosures
Indices are not collective investment funds and are unmanaged. It is not possible to invest directly in an S&P index. Pastperformance of an index is not an indication of future results.
The inception date for the S&P High Yield Dividend Aristocrats Index is November 9, 2005 at the market close. This index hasnot been in existence prior to that date. All information for these indices prior to November 9, 2005 is back-tested. The back-test calculations are based on the same methodology that was in effect at the time that the index was launched. The actualperformance period shown begins November 9, 2005 at the market close. During the December 2010 annual rebalancing,changes were made to the methodology for the S&P High Yield Dividend Aristocrat Index. Complete index methodologydetails document available at www.indices.standardandpoors.com.
The inception date for the S&P International Dividend Opportunities Index is January 25, 2008 at the market close. This indexhas not been in existence prior to that date. All information for these indices prior to January 25, 2008 is back-tested. Theback-test calculations are based on the same methodology that was in effect at the time that the index was launched. Theactual performance period shown begins January 25, 2008 at the market close. In September 2010, major enhancementswere made to the S&P International Dividend Opportunities Index. Complete index methodology details document availableat www.indices.standardandpoors.com.
Complete index methodology details document available at www.indices.standardandpoors.com.
The inception date for the S&P U.S. Preferred Stock Index is September 15, 2006 at the market close. This index has notbeen in existence prior to that date. All information for these indices prior to September 15, 2006 is back-tested. The back-testcalculations are based on the same methodology that was in effect at the time that the index was launched. The actualperformance period shown begins September 15, 2006 at the market close. Complete index methodology details documentavailable at www.indices.standardandpoors.com.
The inception date for the S&P National AMT-Free Municipal Bond Index is September 11, 2007 at the market close. Thisindex has not been in existence prior to that date. All information for these indices prior to September 11, 2007 is back-tested.The back-test calculations are based on the same methodology that was in effect at the time that the index was launched. Theactual performance period shown begins September 11, 2007 at the market close. Complete index methodology detailsdocument available at www.indices.standardandpoors.com.
The inception date for the S&P National AMT-Free Municipal Bond Index is August 31, 2007 at the market close. This indexhas not been in existence prior to that date. All information for these indices prior to August 31, 2007 is back-tested. Theback-test calculations are based on the same methodology that was in effect at the time that the index was launched. Theactual performance period shown begins August 31, 2007 at the market close. Complete index methodology details documentavailable at www.indices.standardandpoors.com.
The inception date for the S&P National AMT-Free Municipal Bond Index is August 29, 2008 at the market close. This indexhas not been in existence prior to that date. All information for these indices prior to August 29, 2008 is back-tested. Theback-test calculations are based on the same methodology that was in effect at the time that the index was launched. Theactual performance period shown begins August 29, 2008 at the market close. Complete index methodology details documentavailable at www.indices.standardandpoors.com.
Prospective application of the methodologies used to construct the Treasury Bond Index and the second backtested period ofthe ICB Index may not result in performance commensurate with the backtested returns shown. The backtested periods do notnecessarily correspond to the entire available history of the indexes. Please refer to the methodology papers for both indexes,available at www.standardandpoors.com for more details about the indexes, including the manner in which they arerebalanced, the timing of such rebalancing, criteria for additions and deletions and index calculation. The indexes are rules
based, although the Index Committee reserves the right to exercise discretion, when necessary. Where applicable foreignexchange conversions to U.S. dollars are calculated on a daily basis.
The index performances shown have inherent limitations. The index returns shown do not represent the results of actualtrading of investor assets. Standard & Poor’s maintains the indexes and calculates the index levels and performance shown ordiscussed, but does not manage actual assets. Indices are statistical composites and their returns do not reflect payment ofany sales charges or fees an investor would pay to purchase the securities they represent. The imposition of these fees and
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charges would cause actual and backtested performance to be lower than the performance shown. For example, if an indexreturned 10 percent on a $100,000 investment for a 12-month period (or $10,000) and an annual asset-based fee of 1.5percent were imposed at the end of the period (or $1,650), the net return would be 8.35 percent (or $8,350) for the year. Over3 years, an annual 1.5% fee taken at year end with an assumed 10% return per year would result in a cumulative gross returnof 33.1%, a total fee of $5,375 and a cumulative net return of 27.2% (or $27,200).
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Disclaimer
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It is not possible to invest directly in an index. Exposure to an asset class is available through investable instruments basedon an index. Standard & Poor’s and its affiliates do not sponsor, endorse, sell, promote or manage any investment fund orother vehicle that is offered by third parties and that seeks to provide an investment return based on the returns of anyStandard & Poor’s index. There is no assurance that investment products based on the index will accurately track indexperformance or provide positive investment returns. Standard & Poor’s is not an investment advisor, and Standard & Poor’sand its affiliates make no representation regarding the advisability of investing in any such investment fund or other vehicle. Adecision to invest in any such investment fund or other vehicle should not be made in reliance on any of the statements setforth in this document. Prospective investors are advised to make an investment in any such fund or other vehicle only aftercarefully considering the risks associated with investing in such funds, as detailed in an offering memorandum or similar
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