Non-Dividend Income
Income Investments
Many investors group all income investments into a single category, but this overlooks crucial differences in how they generate returns and the risks they carry. A dividend from a common stock is fundamentally different from a coupon payment from a bond or a distribution from a Real Estate Investment Trust (REIT). Each of these assets has a unique structure, underlying source of cash flow, and specific tax treatment.
Here we deconstruct popular dividend-paying securities, which aren’t really dividends. We also clarify their distinct mechanisms to help you understand their individual roles within a portfolio. To see how these income securities relate to a dividend-focused strategy, visit our guide on dividend investing and income.
Understanding Your Investments
Investors may not realize that the structure of some of their investments may not simply be common stock ownership. Investing in something you do not understand adds an avoidable risk to your portfolio. It can also have a negative effect on your portfolio construction. So, let’s take a comprehensive look at some of the most common non-dividend income investments.
Master Limited Partnership (MLP)
A Master Limited Partnership (MLP) is a hybrid investment that combines elements of a limited partnership with a common stock. This combination allows them to have the tax advantages of a partnership and the liquidity of a stock.
A firm can qualify for certain tax benefits if 90 percent of its income is earned through activities relating to natural resources, energy, commodities, or real estate. MLPs are limited to two sectors: natural resources and real estate.
MLP’s Unique Structure
MLPs are structured as a Publicly Traded Partnership. The shares of the limited partners are traded on an exchange like common stock. Investors buy units of the partnership and are referred to as unitholders. MLPs are required to distribute all available cash to their unitholders, so, they pay a regular and predictable distribution to unitholders.
One of their benefits is that MLPs add diversification to your portfolio and are not highly correlated to other assets. However, MLPs are usually offered from very slow-growing industries and do not offer much potential for appreciation. Finally, they are more complicated when it comes to tax preparation and reporting.
Real Estate Investment Trust (REITs)
A Real Estate Investment Trust (REIT) is a company that owns and manages a portfolio of properties that generate income.
Think of a REIT as a mutual fund, but for real estate. Instead of buying a whole apartment building or shopping mall yourself, you can simply buy shares in a REIT that owns many of them. This allows you to invest in real estate without the hassle of being a landlord.
The Special Rule: Why REITs Pay High Dividends
REITs have a special tax advantage. To avoid paying corporate income tax, a company must follow two key rules:
- At least 75% of its income must come from real estate-related sources like rent or mortgage interest.
- It must pay out at least 90% of its taxable income to its shareholders as dividends.
This 90% payout rule is why REITs are so popular for income investors, they are structured to be cash-paying machines.
Public vs. Private REITs
There are two main types of REITs, and for most investors, the difference is crucial.
- Publicly-Traded REITs: These are the most common. They are registered with the SEC and trade on major stock exchanges like the NYSE or NASDAQ. You can buy and sell them through a regular brokerage account just as easily as any other stock, like Apple or Amazon.
- Private REITs: These do not trade on a public exchange. Because of this, they are considered illiquid, meaning you can’t sell your shares easily. Your money could be tied up for years until the REIT is sold or goes public. These are typically designed for institutional investors and are generally not suitable for beginners.
The Pros and Cons of REITs
Investing in a REIT offers several key advantages and one main drawback.
Benefits of REITs
- Steady Income: The 90% payout rule often results in attractive and consistent dividend payments.
- Diversification: They allow you to add real estate to your portfolio without the cost and effort of buying physical property.
- Potential for Growth: In addition to income, the value of the REIT’s shares can grow over time, leading to long-term capital appreciation.
Drawbacks of REITs
- Management Fees: Like a mutual fund, a REIT has a team of professionals managing the properties. The cost of that management is passed on to shareholders through fees
Preferred Stock
Think of a preferred stock as a hybrid investment—it’s part stock and part bond. Its main purpose is to pay a fixed, predictable dividend on a regular schedule, making it a popular choice for investors who want a steady stream of income.
To understand them, it’s easiest to break down their “bond-like” and “stock-like” features.
The “Bond-Like” Features (The Safety Net)
These are the characteristics that make preferred stocks feel safe and predictable, much like a bond.
- Fixed Dividend: Just like a bond pays a set interest rate, a preferred stock is designed to pay a specific, fixed dividend. You know exactly how much income to expect.
- Priority in Line: If a company runs into financial trouble, preferred shareholders get paid before common stockholders. You are higher up in the pecking order, which makes it a safer investment than the company’s common stock.
- “Cumulative” Payments: Most preferred stocks are “cumulative.” This is a great feature that means if the company misses a dividend payment to you, it must pay you back all the missed dividends in full before the common stockholders can get paid again.
The “Stock-Like” Features (The Flexibility)
These are the features preferred stocks share with the common stocks you’re used to.
- Trades on an Exchange: You can easily buy and sell shares of preferred stock through a regular brokerage account, just like any other stock.
- No Maturity Date: Unlike a bond, which has a specific end date, a preferred stock can exist forever. However, the company has the option to “call” the shares, which means it can buy them back from you at a set price.
The Big Tradeoff: Income vs. Growth
Investing in preferred stocks comes with a very clear tradeoff that you need to understand.
Upside: Preferred stocks typically offer a higher dividend yield than both the company’s common stock and its bonds. The income is the main attraction.
Downside: Because the dividend payment is fixed, there’s very little room for the stock price to grow significantly. You are essentially trading the potential for large capital gains for the stability of a higher, more predictable income. You also usually don’t get any voting rights in the company.
Who Offers Preferred Stock?
You’ll most often see preferred shares offered by large, stable companies like banks, insurance companies, utilities, and REITs.
Bonds and Fixed-Income Securities
Bonds and other fixed income securities are essentially loans you make to an organization. When you buy a bond, you are lending money to a government or a corporation. In return, the borrower agrees to pay you fixed interest payments, known as coupons, on a regular schedule, such as twice a year.
At the end of the loan’s term, called its maturity date, the borrower repays your original investment, the principal, in full. This simple structure provides a highly predictable and steady stream of investment income, making it a reliable foundation for many portfolios.
Bonds are generally considered less risky than stocks. This is because bondholders are lenders, and if a company faces bankruptcy, they are legally required to be paid back before stockholders, who are owners. This lower risk leads to a classic investment tradeoff. Because the income from bonds is more predictable and the investment is safer, their expected long term returns are typically lower than those from stocks. You are essentially trading the potential for higher growth for a greater degree of stability and income security.
Covered Calls and Covered Call Funds
Some income investors turn to covered calls as a way to boost the income from their stock portfolio. The income from a covered call also offers you an efficient way to hedge some the risk of the stocks you hold and provides a boost to your return when you sell the stock. However, because covered calls lock in a sell price (the strike price), they can offer limited potential for gain and will not allow you to benefit if the stock has a rapid increase in price. You can learn more about a comprehensive covered call strategy here.
New additions to the investment income game include covered call ETFs and other option income-based ETFs on an index or single security. These securities often lure investors with deceptively high yields. These funds may use complex strategies that sacrifice nearly all potential for stock price appreciation in exchange for generating income. This structural flaw can lead to severe underperformance in rising markets. Furthermore, they typically charge higher management fees than simple index funds, and many possess unproven track records through full market cycles, making their long-term suitability questionable for most buy-and-hold investors.
Other Income Investments
Exploring Other Cash Flow Investments
Beyond common stocks, a diverse world of income investments exists, each with unique rules and risks. REITs allow you to earn from real estate, while preferred stocks provide a fixed dividend with less growth potential. Bonds act as loans to companies or governments, offering stability for lower returns. More complex options like MLPs and option-income ETFs also exist but carry distinct structures and potential drawbacks that require careful consideration before including them in your portfolio.