Income Investing basics investment options that can offer income, growth, and diversification Key questions to consider: What are your income-oriented investment options? What is the role of income in portfolios? What can you do to optimized your porfolio s income potential?
Income investing basics Income investing uses assets such as stocks, bonds, mutual funds, and real estate to seek to generate a stream of income in an investment portfolio to help you meet different needs. This educational primer aims to help you understand how to choose what to include in your portfolio to help generate the income you ll need to meet your investment goals. 1
What are your income-oriented investment options? Income-oriented investments come in many forms and offer an array of potential benefits. Whether you are young and have just begun investing, are in the middle of your career, or are well into retirement, there are income options that can help meet your wealth building, capital preservation, and income needs now and in the future. Get to know the income options A wide range of bonds and dividend-paying equities can help you reach your financial goals. This table provides a brief introduction to many available options. Fixed Income equities / specialty Bonds (a.k.a., fixed income investments) Dividend-Paying Equities REAL ESTATE INVESTMENT TRUSTS (REITs) WHAT ARE THEY? Bonds are debt obligations issued by governments, state and local municipalities, and companies all over the world to fund infrastructure projects and acquisitions, or to provide working capital. Bonds pay interest that can be fixed, floating, or payable at maturity. The maturity date is the date the issuer of the bond repays the principal. Short-term bonds generally mature in 1 to 3 years. Medium- or intermediate-term bonds generally mature in four to 10 years. Long-term bonds are those with maturities greater than 10 years. Companies around the world offer shares of ownership to investors. Typically, larger, more established companies may also share profits with stockholders in the form of dividends. Investment companies create pooled investments that purchase groups of underlying properties. They sell shares of ownership to investors and offer income in the form of dividends. HOW DO THEY WORK? When you purchase a bond, you are lending money to the issuer. The bond represents the commitment to paying you back. Generally, you receive interest payments periodically. At maturity, you receive the par value of the bond. When you purchase stock, you become part owner of a company. Each share represents an equal portion of company ownership. Any dividends you receive are your share of the profits. Dividends are typically paid quarterly. When you purchase a REIT share, you are buying part ownership of all the underlying properties. Each share represents an ownership stake in the REIT. Income received from the properties is paid to you regularly. Please note that fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. The safety of principal is based on the creditworthiness of the issuer. U.S. agency-issued bonds are backed by the full faith and credit of the U.S. government. Investments in dividend-paying equities are subject to the inherent risks of investing in the stock market. There is no guarantee of receiving dividend payments or that dividend payments will continue in the future. 2
INVESTMENT TIP Dividend-paying equities like REITs and MLPs may have more risks than bonds, so make sure to select an investment manager with strong fundamental research, smart stock pickers, and strong performance. Multi-asset class Utilities These companies provide electricity, heating oil, and natural gas. Master Limited Partnerships (MLPs) MLPs are publicly traded partnerships, not corporations, and trade on major stock exchanges such as the New York Stock Exchange. Most MLPs are focused on natural resources and are engaged in the transportation, storage, processing, refining, marketing, exploration, and production of oil and gas, and the mining of minerals or other natural resources. Multi-Asset Class Investments Multi-asset investment portfolios diversify across a variety of complementary equity, fixed income, and alternative asset classes. When you purchase a share of a utility stock, you become part owner of the company. Each share represents an equal portion of utility company ownership. Any dividends you receive are your share of the profits. Dividends are typically paid quarterly. When you purchase a unit of an MLP, you become a limited partner in the venture. Each unit represents an equal share of the venture. Unlike corporations, MLPs are not subject to federal and state income taxes. This enables them to pass through higher distributions to unitholders. Cash distributions are typically paid quarterly. When you invest in multiple asset classes, you seek to smooth out volatility while providing an attractive source of income. Distributions from MLP and REIT investments may include a return of capital. Investing in real estate poses certain risks related to individual property, credit, and interest rate fluctuations. Utility investments are sector specific, which increases the risks associated with any single economic, political, or regulatory development in the utility market which will affect the performance of the investment. 3
What are your income-oriented investment options? continued Bonds and dividend-paying stocks, including REITs and MLPs, provide income in portfolios in different ways. The following examples show how each type of investment provides income. BONDS There are many types of bonds each with unique risks and return potential. Government bonds are generally considered the safest but offer lower rates than other types of bonds. Income from municipal bonds is often free from federal tax and may be free from state and local taxes as well. Corporate bonds tend to offer higher yields but often have more credit risk than government and municipal bonds. In this hypothetical example, Becky is a bondholder for Company ABC. She purchased her bond at face value for $10,000. In essence, she has loaned the company money. She receives interest twice a year and will be repaid in full at maturity. BECKY S INCOME STREAM Owns $10,000 2-year bond Coupon rate: 4% January Year 1 June Year 1 December Year 1 June Year 2 December Year 2 Total Becky purchases $10,000 2-year bond Becky receives semi-annual interest payments $200 $200 $200 $200 Total income Becky is paid back payments: $800 in full at maturity. Principal bond $10,000 amount paid back to Becky: $10,000 Total = $10,800 Determining a bond s price: The price is based on many variables, including interest rates, supply and demand, liquidity, credit quality, maturity, and tax status. Newly issued bonds normally sell at or close to par, which is 100% of the face, or principal, value. Bonds traded in the secondary market fluctuate in price in response to changing interest rates, credit quality, general economic conditions, and supply and demand. When the price of the bond increases in face value, it is said to be selling at a premium. When a bond sells below its face value, it is said to be selling at a discount. This hypothetical example represents a potential time line for a bondholder and is for illustrative purposes only. It does not reflect the performance of any specific investment, and there is always the possibility that an issuer may default on payment of interest and principle. 4
INVESTMENT TIP Utility stocks offer steady return potential in any market. Most utility companies pay the bulk of their profits in the form of dividends, which provide potential for steady levels of current income. STOCKS Stan is a shareholder of the same company from which Becky purchased her bond as another source of income. One reason he bought the stock was the company s history of paying a portion of its profits in dividends. As you can see, Stan is receiving a stream of income in quarterly dividends as a result of his $10,000 investment. The other reason Stan invested in the company was to benefit from the potential growth of its stock. If the value goes up, Stan could sell at a profit. Even if the price goes down, the stock may continue to pay dividends and offer Stan some downside protection. STAN S INCOME STREAM owns 100 shares of Company ABC share price: $100 ($10,000) 12-month yield: 4%, or $400 January Year 1 March Year 1 June Year 1 September Year 1 December Year 1 March Year 2 June Year 2 September Year 2 December Year 2 Total Stan purchases 100 shares of Company ABC at $10,000 Stan receives quarterly dividends $100 100 $100 $100 $100 $100 $100 $100 Total dividend payments: $800 Stan s shares are worth: $10,000 (at $100 share price) Total = $10,800 This hypothetical example represents a potential time line for a stockholder and is for illustrative purposes only. Not all companies pay a dividend, and those that do can have different payment frequencies (quarterly, semi-annually, annually). It does not reflect the performance of any specific investment. Also, there is no guarantee that dividends will continue to be provided in the future. 5
What is the role of income in portfolios? REDUCE PORTFOLIO VOLATILITY Since 2000, market volatility has increased dramatically. Over the past 15 years, there have been two major equity market drawdowns. Extreme market moves often cause investors to act emotionally, which can take a toll on investment returns and values. Bonds can help balance risk and return Income-producing investments like bonds have helped reduce volatility in stock portfolios while not generally having a major impact on long-term performance. Investors who diversify may be more likely to stay the course. Adding bonds to the same stock portfolio helped reduce sudden changes in performance. 30,000 25,000 20,000 Stocks and Bonds $24,084 Stocks $23,287 15,000 10,000 5,000 0 2000 2005 2010 2015 2016 INVESTMENT TIP Determine which combination of stocks and bonds is right for you by talking to your financial professional. Source: Calculated by PGIM Investments using data presented in Morningstar software products. All rights reserved. Used with permission. Past performance is no guarantee of future results. Time period: 12/31/1999 to 12/31/2016. Stocks are represented by the S&P 500 Index. Bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond Index, an unmanaged index that covers the U.S. dollar-denominated, investment-grade, fixed rate, taxable bond market of Securities and Exchange Commissionregistered securities. The stock and bond portfolio is a 50% stock and 50% bond mix rebalanced annually. Past performance is no guarantee of future results. This chart does not reflect the performance of any specific investment. An investment cannot be made directly in an index. 6
GROW YOUR PORTFOLIO Many people don t think about stocks for income. But dividend-paying stocks have the potential to provide the income and downside protection you d expect from bonds, plus the growth potential of equities. Dividend income has historically been a major component of stock returns. Reinvest dividends for maximum portfolio growth The share prices of dividend-paying equities can rise or fall. Similarly, dividends can increase or decrease. Together, price and dividend return potential may come with the opportunity to grow your initial investment and your income stream. Plus, if you choose to reinvest your dividends to purchase more shares of stock, you may be able to increase your total return and maximize your growth potential. To reinvest, simply select the reinvest dividends option when you purchase a stock or stock mutual fund. The ending value of the stock portfolio that reinvested dividends was approximately 37% higher than the portfolio that did not reinvest dividends. $25,000 20,000 Stock portfolio that reinvests dividends $23,287 +37% 15,000 10,000 $16,957 Stock portfolio that does not reinvest dividends 5,000 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Calculated by PGIM Investments using data presented in Morningstar software products. All rights reserved. Used with permission. Past performance is no guarantee of future results. Time period: 12/31/1999 to 12/31/2016. Hypothetical growth of $10,000 portfolio is represented by the S&P 500 Index. Returns are based on index performance and do not include sales charges, fees, or expenses. If these were included, returns would be lower. Total return represents the return, including capital appreciation and reinvested dividends, of the S&P 500 Index, annualized. This chart does not reflect the performance of any specific investment. An investment cannot be made directly in an index. 7
What is the role of income in portfolios? continued FIGHT INFLATION When stock prices increase, wealth can be created. But when consumer prices increase creating inflation, that wealth can erode. Inflation may be quite harmful to your portfolio and your lifestyle. Inflation refers to the rate at which prices are rising and is measured by changes in the Consumer Price Index (CPI), a weighted average of prices of consumer goods and services, such as housing, food, transportation, and medical care. REITs are built to help fight inflation Dividend-paying equities can help you fight inflation through stock market growth and income, which may help your assets values keep pace with rising costs over the long term. Commercial real estate properties can provide income that keeps pace with inflation through yearly increases built into their leases. Real estate investment trusts that invest in these properties have often outperformed inflation. Over the past 30 years, REITs have produced an average annual income of approximately 7%, more than double the average rate of inflation.* 12 REIT Income Return Inflation 8 4 0 1987 1990 1995 2000 2005 2010 2016 * Source: NAREIT. REIT income return for the Financial Times Stock Exchange National Association of Real Estate Investment Trusts (FTSE NAREIT) All REITs Index, 1987 to 2016; reinvested dividends, sales charges, fees, and expenses not included. If these were included, returns would be lower. This index is an unmanaged, marketcapitalization-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. Past performance is no guarantee of future results. An investment cannot be made directly in an index. INVESTMENT TIP In return for favorable tax treatment, REITs are required to pay out 90% of their annual taxable income as dividends, providing investors with a way to earn current income. 8
PROVIDE POTENTIALLY TAX DEFERRED INCOME An MLP s cash flow is typically paid out quarterly to unitholders. Distributions can be classified as cash distributions or as return of capital (ROC), which is the portion of the original cost basis that has been amortized for depreciation. Taxes are due on cash distributions immediately at ordinary income tax rates, whereas taxes on ROC are deferred until the investment is sold. MLPs provide higher yields that are largely tax-deferred MLPs offer more attractive yields relative to stocks and REITs, and an MLP s entire taxable income may be offset by depreciation and amortization. The majority of MLP distributions are classified as ROC, which reduces an investor s cost basis. MLP cash distributions are taxed immediately at ordinary income tax rates but ROC (which is typically 80% 90% of MLP distributions) are tax deferred and treated as a tax credit until final sale. 7.1% Strong Yields 1 MLP distributions typically have two components that are taxed differently 10 20% Income 4.0% 3.6% 2.0% 80 90% Return of Capital MLPs REITS Utilities S&P 500 Index 1 Source: FactSet and Bloomberg based on trailing 12-months as of 12/31/2016. MLPs are represented by the Alerian MLP Index, REITs are represented by the FTSE NAREIT All Equity REITs Index, S&P 500 is represented by the S&P 500 Index, and Utilities are represented by the S&P 500 Utility Index. For illustrative purposes only. 9
What can you do to optimize your portfolio s income potential? TAKE A DIVERSIFIED APPROACH Each of the investments discussed offers potential advantages but comes with risks. Diversification can help manage investment risks. Using mutual funds to diversify your portfolio is easy and affordable because they enable you to invest in large pools of securities for less than purchasing them on your own. Please keep in mind that diversification does not guarantee a profit or protect against loss in declining markets. A spectrum of diversified income investments Today, you have access to a wide range of mutual funds from around the world. Fixed Income GOVERNMENT BOND FUNDS MUNICIPAL BOND FUNDS CORPORATE BOND FUNDS EQUITY INCOME FUNDS Government bond funds invest in Treasurys, U.S. government agencies, and U.S. mortgages, or they may focus on international and emerging market government debt. Government bonds may offer lower interest rates than other types of bonds, but they are generally safer. U.S. government bonds, or Treasurys, are backed by the full faith and credit of the U.S. government. Municipal bond funds invest in bonds of specific states or municipalities across the United States, or in the local debt of emerging markets. The income from U.S. municipal bonds is often federal tax free, and it may be free from state and local taxes as well. Investment-grade domestic municipal bonds are slightly riskier than Treasurys, but they may offer a bit more interest. High yield domestic and international municipal bonds may carry additional risks associated with credit history, local politics, or currency movements. Corporate bonds are often part of a diversified bond fund. They can also be the focus of funds like short-term corporate bond funds or high yield corporate bond funds. Domestic and international corporate bonds offer higher yields and higher risk, as corporations (especially those with lower credit ratings) have a higher risk of default than municipalities or governments. Equity income funds generally invest in stocks of firms known for paying moderate dividends. They tend to be larger, more established firms that are believed to be undervalued by the market. As a result, they may have the potential for capital appreciation. The trade-off for the potential to grow both principal investment and income is the risk that your investment may lose value. REDUCE VOLATILITY GROW PORTFOLIO FIGHT INFLATION PROVIDE POTENTIAL TAX ADVANTAGES 10
INVESTMENT TIP Work with your financial professional to develop a regular withdrawal plan to deliver the income stream you need from your portfolio. Remember, the longer you can live off your interest or dividends, the more opportunity your principal has to grow. By investing in a variety of asset classes, you can create a powerful investment mix that can help create more income, protect your principal, increase your wealth, and fight inflation. Equities / SPECIALTY Multi-asset class UTILITY FUNDS REAL ESTATE INVESTMENT TRUSTS MASTER LIMITED PARTNERSHIPS (MLPS) Multi-asset class investments Utility funds can often invest across different types of utilities and utility-related companies to find the potential for capital appreciation and current income. Utilities offer the potential for higher current income streams than bonds, but they come with the risk of loss of investment principal. REITs can invest in properties both inside and outside the United States. REIT mutual funds may focus on U.S. REITs, international REITs, or global REITs (both domestic and international) to take advantage of real estate opportunities anywhere in the world. Rental income can translate into levels of current income that may surpass inflation. MLP funds can often invest in midstream companies that build, acquire, and operate transportation, processing, and storage facilities. Midstream operations tend to be more stable and provide more predictable cash flows. MLPs generally offer distributions that are higher than other asset classes. Historically, MLPs have shown low correlation with broader markets. Multi-asset investments offer diversification by investing in multiple asset classes, which could include a mix of dividend-paying stocks, convertible bonds, REITs, emerging market debt, high yield bonds, MLPs, preferred stocks, among other investments. Many multi-asset investments are designed with a goal of producing an attractive income stream with less volatility. 11
Risk Information Mutual fund investing involves risks. Some funds are riskier than others. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Lower-rated fixed income investments ( junk bonds ) have speculative characteristics, including particularly credit risk. Investments in foreign securities are subject to currency risk and to economic and political developments in countries where the foreign issuer is located or the security is traded. Also, investments in emerging markets may be less liquid and subject to more price volatility than investments in developed countries. Investments in dividend-paying equities are subject to the inherent risks of investing in the stock market. There is no guarantee of receiving dividend payments or that dividend payments will continue in the future. Investing in real estate poses certain risks related to individual property, credit, and interest rate fluctuations. Real estate investment trusts (REITs) may not be suitable for all investors. There is no guarantee a REIT will pay distributions given the inherent risks associated with the market. A REIT may fail to qualify as a REIT as defined in the Tax Code, which could affect operations and negatively impact the ability to make distributions. There is no guarantee a REIT s investment objectives will be achieved. Investing in master limited partnerships (MLPs) and MLP-related investments involves risks such as potential conflict of interest risks, cash flow risks, dilution risks, and risks related to the general partner s right to require unitholders to sell their common units at an undesirable time or price. Utility investments are sector specific. Investing in a specific sector increases the risks associated with any single economic, political, or regulatory development in the utility market which will affect the performance of the investment. Foreign securities are subject to currency fluctuations and political uncertainty. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost. There is no guarantee that dividends and/or distributions will be paid. Keep in mind that diversification does not ensure a profit or protect against losses in a falling market. Fund distributions are taxable and will be taxed as ordinary income or capital gains, unless investing through a tax-deferred arrangement such as a 401(k) plan or IRA. Such tax-deferred arrangements may be taxed at or upon withdrawal of monies from those arrangements. Dividends and distributions from the fund may also be subject to state and local income tax in the state of residence. Neither Prudential Financial, its affiliates, nor their licensed sales professionals provide legal or tax advice. You should consult with your legal and tax advisors for advice concerning your particular situation. Definitions Alerian MLP Index is a composite of the 50 most prominent energy master limited partnerships (MLPs) that provides investors with an unbiased, comprehensive benchmark for this emerging asset class. Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S.-dollar-denominated, fixed rate, taxable bond market. FTSE NAREIT All Equity REITs Index is an unmanaged index which measures the performance of all U.S. real estate investment trusts. S&P 500 Index is a market-weighted index of 500 of the largest U.S. stocks in a variety of industry sectors. S&P 500 Utility Index is an unmanaged, market-capitalization-weighted index including those companies considered electric, gas, or water utilities, or companies that operate as independent producers and/or distributors of power. Indices are unmanaged and an investment cannot be directly made into an index. 12
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