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Building a portfolio for income

Potential income-generating options, and how you might put them together.

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This year, interest rates rose from near-record lows as the market began to anticipate changes in monetary policy by the Federal Reserve. But despite the rise, rates are still historically low, and many investors have struggled to produce income from their portfolio.

Do you stick with historically “safe” Treasuries and their low yields? Or reach out for higher yields and the risks that come with them? Or do you consider non-bond income-generating investments like dividend-yielding stocks or real estate investment trusts? And are you better off with individual securities, funds, annuities, managed accounts, or some combination?

There is no one right answer—you need to examine complex trade-offs between growth, guarantees, access, and inflation protection and make sure your strategy works for your unique goals, time horizon, and risk tolerance. A key part of your strategy should be how to manage guaranteed income sources, which include Social Security, pensions, and annuities. But you may also want or need to generate income from your investment portfolio. And regardless of your stage in life, there may be times you want to generate income for a specific goal—to pay college bills, for example.

Also, your tax situation will come into play. After all, it's not what you make but what you keep after tax that counts. So, although this Viewpoints article doesn’t delve into the nitty-gritty of the tax treatment of investment income, which can vary greatly depending on what you own and your overall financial situation, you’ll want to discuss that with a tax professional.

To help you get started in your analysis, we lay out some of the options—and the trade-offs—along a risk-reward spectrum. Then we show a few examples, based on strategies used in Fidelity funds, of how different types of investors with differing goals and investing styles might piece together a portfolio with the potential to generate income.

Investment options

Let’s start with the basics, beginning with higher-risk, non-bond options and ending with government bonds.

Qualified dividend-paying equities. These stocks offer a combination of income and growth potential—attractive attributes for investors who need to fund a retirement that may last two decades or more. Owning stocks has historically meant more volatile returns than bond investments. But recently, resilient corporate profits and low interest rates have led more income-oriented investors to brave those risks for higher yields. The yield on the S&P 500® was 1.97% as of October 1. And don’t ignore the growth potential of companies based overseas, some of which may provide stronger dividend payments than their domestic counterparts.

"Unlike bonds with fixed coupons, dividend-paying stocks can offer a rising income stream over time as dividends grow with earnings," says Scott Offen, a Fidelity portfolio manager who invests in dividend-paying stocks. "Rising income and the potential for capital gains may offset inflation more easily than fixed income alternatives," he adds. In addition, according to Offen, there are several reasons dividends may have become particularly attractive recently. "Corporations have been healthy and have high cash reserves and resilient earnings, giving companies the ability to maintain and potentially increase future dividend payouts. The current payout ratios (that is, the proportion of earnings required to sustain current dividends) are near historic lows—suggesting ample room to grow and sustain dividends. Finally, dividend yields are attractive on a historical basis versus the 10-year Treasury."


 Income investment options
Performance, risk, and yield
(August 31, 2008–August 30, 2013)
Investment option Five-year annualized
returns
Risk
(standard deviation)
Current yield
Equities     7.31% 18.58% 1.9%
Convertibles 8.40% 16.01% 3.04%
Preferred stocks 4.30% 21.74% 6.09%
REITs 5.67% 30.35% 4.26%
High-yield bonds 11.27% 13.79% 6.65%
Leveraged loans 6.89% 11.12%
5.20%
10-year Treasury bonds 5.01% 8.93% 2.59%
TIPS 4.19% 7.63% 2.17%
Investment-grade corporates 7.34% 7.72% 3.24%
Municipals 4.52% 5.06% 3.09%
This table is for illustrative purposes only. Data according to Bank of America (BofA) Merrill Lynch, Standard & Poor's, and FactSet, FMRCo, as of August 30, 2013. Return and standard volatility measures represent the annualized return for the five years through July 31, 2013. Past performance does not guarantee future results. Standard deviation shows how much variation there is from the “average” (mean, or expected value). Each asset class was represented by an index. Equities—the S&P 500 Index; Convertible securities—BofA Merrill Lynch All U.S. Convertibles Index; preferred stocks—BofA Merrill Lynch Fixed Rate Preferred Securities Index; REITs—FTSE NAREIT All REITs; high-yield bonds—BofA Merrill Lynch US High Yield Master II Constrained Index; leveraged loans—Standard & Poor’s/LSTA Leveraged Performing Loan Index; Treasury—Barclays 10-Year U.S. Treasury Bellwether Index; TIPS—Barclays U.S. Treasury Inflation Protected Securities (TIPS) Index; municipals—Barclays Municipal Bond Index; investment-grade bonds—Barclays U.S. Corporate Investment-Grade Bond Index

International fixed income options

Just like in the U.S., investment-grade and high-yield debt markets operate in countries around the world. In fact, international debt markets have the potential to give you exposure to many of the fastest-growing and most powerful economies in the world.

Investors can choose from:

  • Developed market debt. While the United States and some European nations have struggled with significant debt issues, that doesn’t mean you should abandon the asset class.
  • Emerging market bonds. The risk profile of emerging market debt has changed dramatically over the last 15 years. Joanna Bewick, lead manager of the Fidelity Strategic Funds, notes that more than 60% of emerging market countries are now considered to be investment grade.

Investing in international debt can help diversify your income portfolio. “Investing in non-U.S. debt lets you diversify your interest rate regimes, and gives you coupon payments that may be higher than what’s available in U.S. Treasury markets,” says Bewick. “They also add currency diversification by moving a portion of your portfolio away from the dollar.”

However, these added benefits also introduce new elements of risk, including a range of policy decisions and currency conversions.

Convertibles. These instruments—bonds that give you the option of converting to stock at a set price—provide another way to diversify. They offer some of the upside of equities, but because of that flexibility, they tend to offer lower interest rates than bonds issued by the same company. Convertibles have some risks, including the possibility that the issuer will “call” the security, meaning the issuer can force a conversion. For those willing to accept the risks, convertibles may offer more upside than some types of bonds.

Preferred stocks. These have characteristics of both stocks and bonds. While they are equity securities—that is, they represent an ownership stake in the issuing company—they tend to offer bond-like dividend yields and more limited growth potential than shares of common stock. As of August 30, the current yield on the BofA Merrill Lynch Preferred Securities Index was 6.65%, while investment-grade corporate bonds offered 3.24%, and the S&P 500 paid 1.9%.

Preferred stocks also can have call provisions, which tend to favor the issuer. When interest rates decline, the issuer can call the shares back and reissue them with a lower dividend yield. To avoid this scenario, look for a call protection feature, which limits the stock’s issuer from exercising this option for a designated period of time, usually five years.

“About one-third of the preferred stocks we follow are beyond their call date,” says Joanna Bewick, a Fidelity portfolio manager who specializes in income strategies. “If you pay $102 per share, and they’re called at $100, you lose money,” she explains. “Without call protection, you can eat into the yield and turn your investment negative.”

Real estate. For a long time, residential real estate was considered a safe investment, thanks to its ability to produce regular rental income, as well as the tax deductions. And in recent months the housing market has been recovering. But the sharp downturn in housing during the last recession underscored the risks of relying heavily on rental income.

In the most recent cycle, the fundamentals of the commercial real estate market were more stable than those of the residential real estate market. As a result, real estate investment trusts (REITs), while potentially volatile, can still make sense in a diversified equity portfolio. “The downturn in REITs in recent years has had more to do with the financing crisis than with the fundamentals of supply and demand,” says Joanna Bewick, lead manager of Fidelity's Strategic Funds. “Demand may have been weak, but there wasn’t a gross oversupply, so the fundamentals are rather healthy, and I still think you can earn incremental return there. It’s not a market for the uninitiated, though.”

Bewick notes that sectors like senior housing and health care facilities may offer long-term value, given the demographics of an aging population. However, she warns that more economically sensitive industries like retail and hospitality may elevate volatility and overall portfolio risk.

With REITs, there are a number of ways to invest—from investment-grade bonds to the equities of the REITs themselves. Generally, bond interest and REIT distributions are taxed at rates up to 35%.

“Folks who are lower-risk investors are likely going to find themselves more attracted to real estate fixed income, and perhaps as your risk tolerance increases, you consider things like preferreds or the common equity of REITs themselves,” says Bewick. “So it’s a question of deciding what your risk tolerance is, and where you feel comfortable in the capital structure when it comes to real estate entities.”

High-yield bonds. Notable for their low credit ratings, high-yield bonds, issued by companies and governments worldwide, reward investors with higher rates of interest than do investment-grade corporate bonds, to compensate for their significantly higher risk of default. Recently, high-yield bonds have offered a current yield of 6.65%, considerably more than investment-grade corporate bonds, at 2.76%. However, the volatility of high-yield bonds has been on display as well. The five-year annualized standard deviation shows how much returns have varied over time—high-yield investors had a bumpier ride, with a standard deviation of 13.79%, compared with corporate bonds, with a standard deviation of 7.72%.

Leveraged loans. These bank loans have coupons that reset periodically and are viewed as an asset that could provide some protection against rising rates. These securities invest in the leveraged loans of high-yield companies and have interest rates that are set at a spread above a base rate—typically LIBOR (London Interbank Offered Rate). And these loans are “senior” to high-yield bonds, meaning leveraged loan investors are paid first if the company goes bankrupt.

These two characteristics can potentially make a leveraged loan fund less subject to credit risk and interest rate risk than might be the case with a longer-duration high-yield bond fund, while still providing more income potential than some more conservative asset classes. The ability to adjust to rising interest rates may make these bonds attractive, but keep in mind that it also means these investments inherently have higher refinancing/repricing risk. Unlike other credit investments, which may have non-call periods when the bonds cannot be redeemed, leveraged loans are callable at par at any time.

Investment-grade corporate bonds. These securities are issued by corporations that earn credit ratings of BBB or higher from Standard & Poor’s, and Baa or higher from Moody’s. These bonds carry a higher risk of default than Treasuries of comparable maturities. But as a result, corporate bonds tend to offer higher rates of interest than government bonds do.

“Investors who are looking for income and preservation of capital from their investments may also want to include investment-grade bonds in their portfolio,” says David Prothro, a Fidelity portfolio manager who manages corporate bond funds. “Corporate bonds provide an opportunity to choose from a variety of sectors, structures, and credit-quality characteristics to meet investment objectives.”

Treasury bonds. Ten-year Treasuries offered around 2.59% interest on July 31, 2013. While that’s not a tremendous yield, Treasury securities remain an important, high-quality component of a long-term investment strategy. Because they are issued by the government, they are considered a very conservative investment, even after the August 2011 credit downgrade by Standard & Poor’s. The reliable income they provide may give you the flexibility to take on somewhat more risk in other parts of your portfolio.

Treasury Inflation-Protected Securities (TIPS). A TIPS bond functions like any other Treasury, and with the government backing the bond it may be considered lower risk. But unlike a normal Treasury, the principal is adjusted for inflation, so if inflation drives the value of the bond up, the interest payment and principal due at maturity will increase. TIPS may start off paying less than a comparable Treasury bond, but if inflation takes off, they may pay more in the long run.

“Conventional bonds offer a fixed income stream, the purchasing power of which is eroded by inflation,” says Bill Irving, a Fidelity portfolio manager who specializes in government bonds. “TIPS counter that erosion: The cash flows of TIPS are increased by the amount of inflation. TIPS could play an important role in an overall diversified portfolio.”

One thing to keep in mind, however: TIPS can generate "phantom income," which means you could have to pay taxes as the value of the bond rises with inflation, even though you may not receive a payment until the bond reaches maturity. So you’ll want to consider the tax implications before investing.

Municipal bonds. The interest income earned from most municipal bonds is generally exempt from federal income taxes. What’s more, if you live in the state that issues the bonds, the income may also be exempt from state and local income taxes. “The tax advantages of municipal bonds contribute to their appeal for many investors,” says Jamie Pagliocco, director of municipal bond portfolio managers at Fidelity. "Generally speaking, the higher one’s tax bracket, the greater the likelihood that an investor will find municipal bonds an attractive addition to his or her fixed income allocation.” Municipal bonds on the whole tend to offer high credit quality. That said, some issuers currently face a challenging fiscal environment that may negatively impact their credit profile. So it’s critical to do your credit research. If you don’t have the time or ability to do so, a mutual fund or managed account may be a better option.

Combining income assets

Your strategy for building a portfolio of various income-producing assets will depend on your situation—in particular, your goals and your tolerance for investment risk. While each individual needs to decide what mix is right for him or her based on his or her own research and situation, below we show the makeup of three different Fidelity funds to illustrate  how these different products might come together in a portfolio.

Making choices

Developing the right strategy for you requires understanding your particular needs, goals, and temperament. There are a number of different ways you can try to achieve your income goals. You may want to build your own portfolio, either as an individual or in partnership with a financial adviser. Or you may choose a fund that combines different asset classes for you with an eye on growth, capital preservation, or outpacing inflation. Another option is a managed payout fund, which allocates your investments among many options while attempting to provide a disciplined approach to spending down your capital.

If you want to avoid the uncertainty of a traditional investment portfolio and lock in a guaranteed income stream that you can’t outlive, you may want to consider a fixed or variable annuity. Although it may limit your flexibility and growth potential, an annuity can provide peace of mind—and make it easier to stick with the rest of your investment portfolio through market ups and downs. Finally, a managed account can deliver professional portfolio construction and management.

Next steps

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Before investing, consider the investment objectives, risks, charges, and expenses of the fund or annuity and its investment options. Call or write for a free prospectus or, if available, a summary prospectus containing this information. Read it carefully.

S&P defines a rating BBB as “Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.”
Past performance is no guarantee of future results.
Investing involves risk, including the risk of loss.
Diversification and asset allocation do not ensure a profit or guarantee against loss.
1. Guarantees are subject to the claims-paying ability of the issuing insurance company.

Fidelity Income Strategy Evaluator is an educational tool.

Information provided in this article is general in nature, is provided for informational purposes only, and should not be construed as investment advice. The views and opinions expressed by the speakers are their own as of October 22, 2013 and do not necessarily represent the views of Fidelity Investments. Any such views are subject to change at any time based on market or other conditions. Fidelity Investments disclaims any liability for any direct or incidental loss incurred by applying any of the information in this article. As with all your investments through Fidelity, you must make your own determination as to whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and your evaluation of the security. Fidelity is not recommending or endorsing these investments by making this article available to its customers. Consult your tax or financial adviser for information concerning your specific situation.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Leveraged loans typically contain maintenance covenants that stipulate certain financial tests the company must meet every quarter.
Leverage can magnify the impact of adverse issuer, political, regulatory, market, or economic developments on a company. A decrease in the credit quality of a highly leveraged company can lead to a significant decrease in the value of the company's securities. In the event of bankruptcy, a company's creditors take precedence over the company's stockholders.
The municipal market can be affected by adverse tax, legislative, or political changes, and by the financial condition of the issuers of municipal securities.

Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Increases in real interest rates can cause the price of inflation-protected debt securities to decrease.

Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry, which may affect the fund.

Interest income generated by Treasury bonds and certain securities issued by U.S. territories, possessions, agencies, and instrumentalities is generally exempt from state income tax but is generally subject to federal income and alternative minimum taxes and may be subject to state alternative minimum taxes.

Generally, among asset classes stocks are more volatile than bonds or short-term instruments. Government bonds and corporate bonds have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. U.S. Treasury bills maintain a stable value if held to maturity, but returns are generally only slightly above the inflation rate.
Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. These risks are particularly significant for funds that focus on a single country or region.
ETFs may trade at a discount to their NAV and are subject to the market fluctuations of their underlying investments.
Indexes are unmanaged and you cannot invest directly in an index.
The BofA Merrill Lynch All U.S. Convertibles Index is a market capitalization–weighted index of domestic U.S. corporate convertible securities, including mandatory convertible preferreds.
The FTSE National Association of Real Estate Investment Trusts (NAREIT) US All REITs Index is a market capitalization–weighted index that tracks the full universe of common shares of all tax-qualified real estate investment trusts listed on the New York Stock Exchange, American Stock Exchange, and NASDAQ.
The BofA Merrill Lynch DRD Eligible Preferred Securities Index is a market capitalization–weighted index of fixed-rate U.S. dollar-denominated preferred securities issued in the U.S. domestic market. It is a subset of The BofA Merrill Lynch Fixed Rate Preferred Securities Index. Qualifying securities must have an investment-grade-rating (based on an average of Moody’s, S&P, and Fitch) and an investment grade rated country of risk. In addition, qualifying securities must be issued as public securities or through a 144a filing; must be issued in $25, $50, or $100 par/liquidation preference increments; must have at least one year until final maturity; must have a fixed coupon or dividend schedule; and must have a minimum amount outstanding of $100 million.
The BofA Merrill Lynch BB US High Yield Constrained Index is a modified market capitalization–weighted index of U.S. dollar-denominated below-investment-grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have an average rating (based on Moody’s, S&P, and Fitch) between BB1 and BB3, inclusive, and an investment-grade-rated country of risk. In addition, qualifying securities must have at least one year remaining to final maturity, a fixed coupon schedule, and at least $100 million in outstanding face value. Defaulted securities are excluded. The index contains all securities of the BofA Merrill Lynch BB US High Yield Index but caps issuer exposure at 2%.
The MSCI USA High Dividend Yield Index is a market capitalization-weighted index of stocks designed to measure the performance of the high dividend yielding segment of the U.S. large- and mid-cap equity market. Real estate investment trusts (REITs) are excluded. Eligible companies must have a persistent and sustainable dividend and a dividend yield that is meaningfully higher than average for the parent MSCI ACWI (All Country World Index) USA Index.
The Standard & Poor’s/Loan Syndications and Trading Association Leveraged Performing Loan Index is a market value-weighted index designed to represent the performance of U.S. dollar-denominated institutional leveraged performing loan portfolios (excluding loans in payment default) using current market weightings, spreads, and interest payments.
The Barclays U.S. Treasury Inflation Protected Securities (TIPS) Index (Series-L) is a market value–weighted index that tracks inflation-protected securities issued by the U.S. Treasury. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index.
The Barclays U.S. Aggregate Credit Bond Index is a market value-weighted index of investment–grade corporate fixed-rate debt issues with maturities of one year or more.
The Barclays Municipal Bond Index is a market value–weighted index of investment-grade municipal bonds with maturities of one year or more.
The Barclays 10-Year U.S. Treasury Bellwether Index is an unmanaged index of U.S. Treasury bonds with 10 years' maturity.
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