Only looking at income gets a lot of investors in trouble. In this consumer society we are trained to look for the best deal so who wouldn’t take a 5% return over a 2% return? But total return and principal protection are much more important than income. The biggest problem with many high income investments is that they pay all or part of the high income from your principal. Don’t just look at the interest rate look at where that income is coming from.
An example, suppose your broker offers you a $10,000 A rated 10 year tax free municipal bond priced at $120 with a coupon of 5%. Interest is paid semiannually, its tax free and much more interest than you can get on CD’s. You would probably do it. Now you can tell your friends you are getting 5%. You can tell them that but it is not really the total return you are getting. While you will collect the $500 a year in interest you will lose the $2,000 additional over $10,000 you had to pay for the bond. Your return or yield to maturity will be around 2.5% because while it is true you saw 5% or $500 a year on your statement you have to account for the $2,000 extra you paid for the bond when you calculate your return.
Many guaranteed and protected income annuities are not what they seem. They suck you in with a high interest rates and promises of “guaranteed Income”. What you get mostly is your own money back. Many of these products are ridiculously complicated but here is a very simple example. A single premium immediate fixed annuity (SPIFA) is one where you give the insurance company a lump sum of money in exchange for a fixed amount of income per year for life. Let’s say you are 71 years old and can get $1,000 a month on an SPIFA. You give the insurance company $200,000 and you get $12,000 a year for life.
For the first 16 years they are paying you back with your own money and every year they may be earning more interest on your money than they are paying you. So actually they are paying you back with your own money for longer than 16 years, depending on the return they are earning on your money. You would have to live to at least age 87 just to get your $200,000 back. If you die before then you lose whatever money is left.
Another example would be stocks, master limited partnerships, and real estate investment trusts (REITS) that have high payouts. Many of these hook you with a high return but the company doesn’t make enough to cover the dividends they are paying. In the same scenario as the two examples above they are selling properties or other assets (your own money) to continue to pay you the high dividend. They hook you with the 7,8 or 9% return when the company is actually earning less than that so every year your principal is going down. You are happy because you continue to see that high dividend coming in every year but that is not your true total return.
Many investors swear by dividend paying stocks. But this only works as long as the company keeps earning the dividend they are paying. Once you pick one or two bad dividend paying stocks it will blow up your whole strategy. Remember when the big bank stocks paid 3, 4 and even 5% about 10 years ago? Then some of those dividends went to almost zero during the financial crisis. Remember Kodak? If done correctly a reasonable dividend growth stock strategy can work very well. But if you just chase high income stocks you may get burned.