5 Things Every Income Investor Needs to Know Now

By Carla Pasternak
January 28, 2011

We're sitting on the edge. This year, 2011, marks the tipping point.

Don't worry, it's nothing dangerous. In fact, if you're an income investor, this might be the start of a very prosperous trend.

In 2011, the first of 75 million baby boomers will hit 65 -- the retirement years. You might be among them. This marks a major shift for millions of people that will play out in the next years and decades. And I think it could mean soaring popularity for income investing.

In fact, my colleague Amy Calistri outlined the case in a recent article, Why Bonds Are Almost Certain To See a New Bull Market, in which she said:

"Think about it. Some estimates have this group [baby boomers] controlling more than 80% of personal financial assets -- that's trillions of dollars. Much of that is tied up in housing and other non-liquid investments, but there are still loads of cash in traditional spots. According to the Investment Company Institute, there is $10.7 trillion in mutual funds alone.

“As baby boomers wind down their working years, they're going to do what retirees before them have done -- shift from riskier stocks and commodities into more buttoned-down income investments. In fact, given the rocky market of the past decade and disappearing pensions, the shift could be larger than most people think."

This could lead to a golden age for income investing. But as attractive an opportunity this may be, there is no guarantee the graying of the baby boomers will simply lead to a massive bull market across all income securities. That's why it's still most important to select high-quality ideas. If you do this, then any broad bull market will simply be icing on the cake.

So to help you find the best high-yield plays -- and maximize your returns -- I've rounded up some of my favorite income investing tips. I use these tips personally to help guide my portfolio choices in my newsletter High-Yield Investing [click here to learn more], so no matter your experience level, they should give you an edge in finding the best income investments on the market. And if we see the big shift into income securities in the years and decades ahead, all the better.

Tip #1 - Look off the beaten path. Always remember that yield is a combination of dividends paid and share price. If prices rise, the yield on a security falls, all else being equal.

So what will happen to many of the most popular high-yield spots if millions more are looking for solid income? Their prices would likely rise, pushing yields down.

That's why I think it's valuable to look off the beaten path for higher yields. You have to look into the special classes of securities built for income investors. My years of researching the income field have uncovered even the rarest of these assets, including securities like business development companies, stapled products, master limited partnerships and even exchange-traded bonds. This is where you'll uncover truly mouth-watering yields overlooked by the majority of investors who are focused on common stocks.

Tip #2 - Dividend safety is key. For us income investors, nothing should be held in higher esteem than the safety of our dividends. After all, what's the use of a high dividend if it's only going to be cut a few weeks later?

#-ad_banner_2-#But an amazing thing happens when you follow my first tip and look off the beaten path for income investments.

Common stocks are under no obligation to pay a dividend; they can cut their payments at any time if they please. But I've found a few securities, such as preferred stocks, that can't change or reduce their payments. A number of other little-known securities have the same restrictions, all but guaranteeing you'll be paid a stream of income you can count on.

Tip #3 - Use market downturns to find higher yields. Most investors look at a market downturn as a bad thing, and in fact, I would rather the market rise than fall. But I also appreciate the opportunities that appear in a downturn.

As I said, a stock's yield is a function of its price. If a stock pays $1 a share in dividends and trades at $20, its yield is 5%. If the same stock dips to $10 a share, the yield has risen to 10%.

That's one reason why I bought heavily during the recent market downturn -- the yields became too high to ignore! If you can stomach volatility during a bear market, you'll likely have a chance to lock in unnaturally high yields.

Tip #4 - Don't be afraid to take a loss. My subscribers always ask me when to sell their holdings. And for good reason -- when you sell is just as important as when you buy.

I'm personally never afraid to take a loss. Many investors continue holding losing stocks and hope for a rebound, only to watch them sink further. I've seen this countless times, so I'm always sure to look at the reasons a holding is falling and whether I should sell.

If the stock in general is falling with the market, I may not be worried. However, if a change in the company's operations means it could see rocky times ahead, I don't want a part of it.

Tip #5 - Taxes matter. When is a lower yield more attractive than a higher yield that's just as safe? When the lower yield is taxed at a lower rate.

Consider this: An investor in the top federal tax bracket is invested in a municipal bond that pays 6%. Because the income from this bond is tax-free, the taxable-equivalent yield is actually 9.2%! In other words, if the same investment were in a fully-taxable security, the investor would have to earn 9.2% to have the same income after taxes.

It doesn't take long for that difference to add up to serious cash.

[For more on income investing, visit our InvestingAnswers feature: 4 Steps to Finding the S&P 500's Safest Dividend]