S&P INDICES | Practice Essentials

Income Investing 101

Income Investing A Birds-Eye View of Income Investing: An Investment Strategy with a Renewed Purpose
The U.S. Census Bureau estimates that over 78 million people also known as baby boomers were born between 1946 and 1964. For retired baby boomers or those planning to retire, investing for income generation while mitigating risk plays an important part in their investment planning. Therefore, it is not surprising that interest in income investment strategies is on the rise among financial advisors. Financial advisors design these strategies to deliver income to clients either from the yield of a financial instrument or from a more diversified portfolio of instruments. In this Practice Essentials whitepaper, we explore the similarities and differences among some of the investment choices typically used to build income investing solutions. This analysis goes beyond yield into the role or contribution of income to total return. We also evaluate the diversification potential of this strategy, as viewed through the lens of the correlation of historical returns among income producing asset classes.

U.S. Retirement demographics and the current low-yield environment for CDs and Money Market Funds have generated advisor interest in higher yielding investment instruments.

The quest for yield

Since 2008, performance has suffered for some of the typical incomeproducing choices selected by advisors. As such, the returns on a number of money market deposits, certificates of deposit and short-term treasury instruments are reflective of the low-interest rate and low inflation environment seen today. This result has led more investors to consider adopting an income investing strategy in order to access the elusive yield. This quest for yield may benefit clients as income plays a more significant role in the total return of a security, fund, or portfolio. Yield is an important concept in understanding the potential return of an income-generating investment and, in turn, relating that potential return to other investments. For advisors, it is worth understanding the following distinctions between the different forms of yield associated with various 1 investment opportunities: For common and preferred stock, dividend yield is often quoted. Divided yield is calculated by dividing the dividend by the stock price. For bonds, there are several important calculated yield values: Yield to maturity: the overall return investors will receive based on the price of the bond if held to maturity.

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Please see appendix for descriptions of investment instruments that produce yield for income generation purposes.

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Practice Essentials | Income Investing 101

Yield to worst: the return investors will receive based on the price of the bond and the worst possible outcome, from an investors perspective, resulting from the following events: Bond being paid off earlier than maturity due to a prior optional call provision. Holding the bond to maturity. Taxable equivalent yield: a comparative yield for tax-exempt municipal bonds that relates the tax-exempt yield to the yield required in order for a taxable bond to achieve the same after-tax benefit. Please refer to S&Ps Practice Essentials paper, Taxable Equivalent Yield, for more details. Current yield: At times, corporate bond yields are quoted in terms of Current Yield. Current Yield is calculated by dividing the stated annual interest rate by the current price of the bond.

The current dividend yield of the S&P U.S. Preferred Stock Index is greater than 7%.

The Role of Income in Total Return

Common stock, preferred stock, and bonds all have different income generating characteristics. Chart A below, depicts the income yield generated by several asset classes, as of December 31, 2010. Yields can change dramatically over time. Therefore, indices are used in the chart to measure these asset classes in a broad manner and to help provide transparency into the relative yields of each asset class. Chart 1: Dividend Yield Across Asset Classes
8% 7% 6% 5% 4% 3% 2% 1% 0% S&P Short Term National AMT-Free Municipal Bond Index U.S. Government Bonds U.S. Equities S&P High Yield S&P International S&P National AMT- S&P U.S. Preferred Dividend Aristocrats Dividend Free Municipal Stock Index Opportunities Index Bond Index
Yield 1.46% Taxable Equivalent Yield 2.24% 1.57% 1.81% 3.66% 4.85% Yield 4.00% Taxable Equivalent Yield 6.15% 7.64%

Source: Standard & Poors. Data as of December 31, 2010. Dividend Yield is used for U.S. Equities and Preferred Stock. Yield to Maturity is used for bonds. U.S. Equities are represented by the S&P 500 Index. U.S. High Yield Dividend Equities are represented by the S&P High Yield Dividend Aristocrats Index. U.S. Preferred Stock is represented by the S&P U.S. Preferred stock Index. U.S. Government bonds are represented by the S&P/BGCantor U.S. Treasury Bond Index. Tax-exempt municipal bonds are represented by the S&P National AMT-Free Municipal Bond Index. Short term tax-exempt bonds are represented by the S&P Short Term National AMT-Free Municipal Bond Index. Taxable Equivalent Yield is calculated using an assumed 35% tax rate. Charts, calculations and values used in this analysis are shown for illustration purposes only. An index yield can change over time as it is calculated based on the underlying constituents of the index.

Practice Essentials | Income Investing 101

For both stock and bond investments, dividend and interest income streams contribute to the total return of the investment. Total return measures both the change in price of a security and any additional cash flow holders may have received, including dividends or interest over a specific period of time. Total return calculations do assume that the income is reinvested in the asset class being measured. Total return is an appropriate measure for advisors seeking both growth (price appreciation) and income. However, for clients who need to use the income generated from the strategy, advisors must set different return expectations based on the impact on the portfolio of the rate of payout. To illustrate the impact of income on total return, Table 1 below depicts the contribution to total return of dividends and interest for differing asset classes for the period of 12/31/2009 to 12/31/2010.

Table 1: Index Characteristics: Data through December 31, 2010 Annualized Total Return (7 years) (%) 3.85 Standard Deviation (7 Years) (%) 15.5 Year to Date Total Return (%) 15.06 YTD Income (Dividends or Interest) (%) 2.28

Asset Class U.S Equities U.S. High Yield Dividend Equities International High Yield Dividend Equities U.S. Preferred Stock U.S TaxExempt Municipal Bonds U.S. Short Term TaxExempt Municipal Bonds

Representative Asset Class Index S&P 500 Index S&P High Yield Dividend Aristocrats Index S&P International Dividend Opportunities Index S&P U.S. Preferred Stock Index S&P National AMTFree Municipal Bond Index S&P Short Term National AMT-Free Municipal Bond Index

5.09

16.1

16.80

4.49

13.49

24.2

8.44

5.58

3.46

22.7

14.99

8.62

3.99

5.1

2.30

4.81

3.35%

2.1%

1.59%

4.62%

Source: Standard & Poors. Data as of December 31, 2010. The chart is provided for illustrative purposes and may reflect hypothetical historical performance for some of the returns. Please see the Performance Disclsoure at the end of this document for important information and limitations regarding the calculation of the index as well as the use of hypothetical historical performance.

As the data above shows, annualized total return and the contribution to total return of dividends and interest earned varies. The S&P indices, noted above as benchmarks for the different types of income generating assets, were chosen for two reasons: 1. By construction and methodology, each attempts to measure an investable portion of the asset class in question. 2. Each of the indices has been licensed by a fund provider, and offer advisors an actionable way to capture income via ETFs tracking the relevant index. For a listing of licensed funds on these indices, explained below, visit www.SPindices.com/4solutions.

Practice Essentials | Income Investing 101

Dividend-seeking S&P indices. The case for dividend investing is straightforward upside potential with some downside protection. The downside protection comes from dividends providing a stable source of income even when stocks may be declining in price. S&P High Yield Dividend Aristocrats is an index measuring 50 U.S. domiciled stocks that have paid increasing dividends in each of the previous 25 years. S&P International Dividend Opportunities is an index measuring 100 of the most liquid, high dividend yielding international common stocks or ADRs. Stocks in this index must have five years of earnings growth history and profitability. This index is maintained to cap sector, country, and company weightings.

S&P High Yield Dividend Aristocrats measures 50 U.S. Stocks which have paid increasing dividends over the past 25 years.

As of December 31, 2010, S&P US Preferred Stock measures 224 issues across eight of the ten sectors, with the bulk of holdings coming from the Financials and Consumer Discretionary sectors. S&P International Preferred Stock measures the developed European and Asian Markets. The index was launched in August 2010 to meet demand for an investable benchmark capturing non-U.S. developed markets and the high yields and diversification they may provide. S&P Municipal Bond Indices. Investment-grade municipal bonds are used by some advisors to provide income while maintaining relatively secure principal, assuming the bonds are held to maturity. The S&P National AMT-Free Municipal Bond Indices are broad, comprehensive, market value-weighted indices designed to measure the performance of the investment-grade tax-exempt U.S. municipal bond market. As of December 31, 2010, S&P National AMT-Free Municipal Bond Index consists of approximately 8,428 bonds, with a total market value of approximately US$ 526.9 billion. The index consists of a broad-based national index, as well as state-level and maturity-based municipal bond sub-indices S&P Short-Term National AMT-Free Municipal Bond Index includes all bonds in the National index that have an effective maturity, as measured from the first business day of the month, that is greater than or equal to one month and less than five years. Diversification Potential as Measured by Asset Class Correlations In these volatile times, a diversified approach to income investing may help reduce concentration of risk in any one asset class. Table 2 on the following page shows the seven-year historical correlations of the asset classes previously discussed.

Practice Essentials | Income Investing 101

Table 2: Historical Asset Class Correlations Using Indices

S&P High Yield Dividend Aristocrats Index S&P International Dividend Opportunities Index S&P National AMT-Free Municipal Bond Index S&P Short Term National AMT-Free Municipal Bond Index

7-Year Correlation

S&P 500 Index

S&P U.S. Preferred Stock Index

S&P 500 Index

1.000

S&P US Preferred Stock Index has a 0.581 correlation with the S&P 500 and a 0.262 correlation with the S&P National AMT-free Municipal Bond Index.

S&P High Yield Dividend 0.853 1.000 Aristocrats Index S&P International 0.886 0.716 1.000 Dividend Opportunities Index S&P U.S. 0.532 0.646 1.000 Preferred Stock 0.581 Index S&P National AMT-Free 0.221 0.152 0.225 0.329 1.000 Municipal Bond Index S&P Short Term National AMT-Free 0.027 0.113 0.026 0.262 0.769 1.000 Municipal Bond Index Source: Standard & Poors. Data as of December 31, 2010. This chart is provided for illustrative purposes only and may reflect hypothetical historical performance for some of the indices referenced. Please see the Performance Disclosure at the end of the document for important information and limitations regarding the calculation of the index as well as the use of hypothetical historical performance.

The table above highlights interesting diversification benefits previously achieved by adding certain income-producing funds, as measured by S&P indices, to typical core holdings in a portfolio. In conclusion, income investing, or the strategy of selecting securities or funds based in part on the potential income stream they may provide, may be an effective tool for generating returns. The income of a security (a common stock, preferred share, bond, or fund) plays an important role in the total return of that security. These income strategies do not have to be overly complicated or difficult to implement in a clients portfolio. By tracking the indices described in this paper, an advisor can seek to leverage passively managed products exclusively or in combination with a managed approach to meet client needs for income, greater diversification, and growth or capital preservation potential.

Practice Essentials | Income Investing 101

Appendix
Income Generating Assets Further Explained
Income generating assets include dividends from equity investments, interest from fixed income securities, interest earned from certificates of deposit and income earned in real estate investing. For the purposes of this paper, the focus is placed on income generation from equity and fixed income securities. Income from equity ownership from dividends: Common Stock: Also known as common shares, represents partial ownership in a company, typically with voting rights. o Not all companies pay dividends on common stock. o Dividend payments can fluctuate based on company earnings. o Common stock holders receive dividend payments only after any interest is paid to bondholders and dividends are paid to preferred shareholders. Preferred Stock: Similar to common stock, preferred stock represents partial ownership in the company, but without the voting rights. o Dividends for preferred stock are fixed or preset at issuance. o Preferred stock dividends are usually stated as a percentage of face value (Par) of the preferred share. o Preferred stock dividends are paid prior to common stock dividends, but only if funds are available. o Preferred stock holders have a higher claim on a companys assets in the event of bankruptcy or liquidation. o There are four common types of preferred stock: Cumulative: These shares give their owners the right to "accumulate" dividend payments that were skipped due to financial problems; if the company later resumes paying dividends, cumulative shareholders receive their missed payments first. Non-Cumulative: These shares do not give their owners back payments for skipped dividends. Participating: These shares may receive higher than normal dividend payments if the company turns a larger than expected profit. Convertible: These shares may be converted into a specified number of shares of common stock. Income From Fixed Income Securities From Interest Payments. In general, bonds represent a loan made by investors. In return for the loan, the bond issuer (borrower) promises to repay the amount borrowed (principal) to the bond holders (lenders) at specific date or dates in the future (maturity). In return for borrowing the money, the bond issuer promises to pay bond holders periodic interest (known as a coupon) on the amount of the loan outstanding (also called par or face value). These payments are usually made every six months, up to and until the day the bonds are repaid in full. o For bonds, there are three prominent variations of interest rate types: Fixed rate bonds: Set at issuance, the interest rate on fixed rate bonds remains unchanged throughout the life of the bond. The interest rate is usually stated as a % of par (Par represents 100% of the face value of the bonds). The frequency that interest is paid is set at issuance and common frequency of interest payments are monthly, quarterly, semi-annually, and annually.

Practice Essentials | Income Investing 101

Floating rate or adjustable rate bonds: The interest on these bonds changes periodically based on preset rules. Weekly, monthly, semi-annually, annually, and other schedules for interest rate changes are not uncommon. The interest rate on these bonds is usually tied to a base rate or an index such as LIBOR. Zero coupon bonds: No interest is paid on these bonds. Instead, the bonds are sold at a discount to the face value of the debt and at maturity pay the bond holders the full amount of the loan. The discount to par (face value) is calculated based on the yield associated with the bond. A permutation of zero coupon bonds is deferred interest bonds where all interest that would normally be paid on a periodic basis is accumulated and paid to bond holders at maturity. Bonds are issued by many entities, but the most common issuer types are: Government Bonds - issued by the U.S. Government and include Treasury Bills, Notes, Bonds, and Treasury Inflation Protection Securities. Interest received by bondholders is subject to federal taxation. o Treasury Bills, or T-Bills are sold at a discount to Par and have a maturity range of a few days to 52 weeks. o Treasury Notes, sometimes called T-Notes, earn a fixed rate of interest every six months until maturity. Notes are issued in terms of 2, 3, 5, 7, and 10 years. o Treasury Bonds pay a fixed rate of interest every six months until they mature. They are issued in a term of 30 years. o Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation. Municipal Bonds - issued by states, local governments, and political subdivisions such as school districts, or by governmental agencies and authorities for a wide variety of basic services and public purposes. Many major infrastructure, educational, housing, health care, and public utilities are financed through the use of municipal bond proceeds. Income received from tax-exempt municipal bonds is exempt from federal government taxation. Please refer to the Practice Essentials paper Municipal Bonds: Back to Basics for more information. Corporate Bonds - issued by industrial, financial, and service companies to finance capital investment and operating cash flow. Some bonds have a higher priority or seniority than other bonds issued by the same company. Interest received by bondholders is taxable income.

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Performance Disclosures
Indices are not collective investment funds and are unmanaged. It is not possible to invest directly in an S&P index. Past performance of an index is not an indication of future results. The inception date for the S&P High Yield Dividend Aristocrats Index is November 9, 2005 at the market close. This index has not been in existence prior to that date. All information for these indices prior to November 9, 2005 is back-tested. The backtest calculations are based on the same methodology that was in effect at the time that the index was launched. The actual performance period shown begins November 9, 2005 at the market close. During the December 2010 annual rebalancing, changes were made to the methodology for the S&P High Yield Dividend Aristocrat Index. Complete index methodology details document available at www.indices.standardandpoors.com. The inception date for the S&P International Dividend Opportunities Index is January 25, 2008 at the market close. This index has not been in existence prior to that date. All information for these indices prior to January 25, 2008 is back-tested. The back-test calculations are based on the same methodology that was in effect at the time that the index was launched. The actual performance period shown begins January 25, 2008 at the market close. In September 2010, major enhancements were made to the S&P International Dividend Opportunities Index. Complete index methodology details document available at www.indices.standardandpoors.com. Complete index methodology details document available at www.indices.standardandpoors.com. The inception date for the S&P U.S. Preferred Stock Index is September 15, 2006 at the market close. This index has not been in existence prior to that date. All information for these indices prior to September 15, 2006 is back-tested. The back-test calculations are based on the same methodology that was in effect at the time that the index was launched. The actual performance period shown begins September 15, 2006 at the market close. Complete index methodology details document available at www.indices.standardandpoors.com. The inception date for the S&P National AMT-Free Municipal Bond Index is September 11, 2007 at the market close. This index has not been in existence prior to that date. All information for these indices prior to September 11, 2007 is back-tested. The back-test calculations are based on the same methodology that was in effect at the time that the index was launched. The actual performance period shown begins September 11, 2007 at the market close. Complete index methodology details document available at www.indices.standardandpoors.com. The inception date for the S&P National AMT-Free Municipal Bond Index is August 31, 2007 at the market close. This index has not been in existence prior to that date. All information for these indices prior to August 31, 2007 is back-tested. The back-test calculations are based on the same methodology that was in effect at the time that the index was launched. The actual performance period shown begins August 31, 2007 at the market close. Complete index methodology details document available at www.indices.standardandpoors.com. The inception date for the S&P National AMT-Free Municipal Bond Index is August 29, 2008 at the market close. This index has not been in existence prior to that date. All information for these indices prior to August 29, 2008 is back-tested. The back-test calculations are based on the same methodology that was in effect at the time that the index was launched. The actual performance period shown begins August 29, 2008 at the market close. Complete index methodology details document available at www.indices.standardandpoors.com. Prospective application of the methodologies used to construct the Treasury Bond Index and the second backtested period of the ICB Index may not result in performance commensurate with the backtested returns shown. The backtested periods do not necessarily correspond to the entire available history of the indexes. Please refer to the methodology papers for both indexes, available at www.standardandpoors.com for more details about the indexes, including the manner in which they are rebalanced, the timing of such rebalancing, criteria for additions and deletions and index calculation. The indexes are rules based, although the Index Committee reserves the right to exercise discretion, when necessary. Where applicable foreign exchange conversions to U.S. dollars are calculated on a daily basis. The index performances shown have inherent limitations. The index returns shown do not represent the results of actual trading of investor assets. Standard & Poors maintains the indexes and calculates the index levels and performance shown or discussed, but does not manage actual assets. Indices are statistical composites and their returns do not reflect payment of any sales charges or fees an investor would pay to purchase the securities they represent. The imposition of these fees and

Practice Essentials | Income Investing 101

charges would cause actual and backtested performance to be lower than the performance shown. For example, if an index returned 10 percent on a $100,000 investment for a 12-month period (or $10,000) and an annual asset-based fee of 1.5 percent were imposed at the end of the period (or $1,650), the net return would be 8.35 percent (or $8,350) for the year. Over 3 years, an annual 1.5% fee taken at year end with an assumed 10% return per year would result in a cumulative gross return of 33.1%, a total fee of $5,375 and a cumulative net return of 27.2% (or $27,200).

Practice Essentials | Income Investing 101

Disclaimer
This document does not constitute an offer of services in jurisdictions where Standard & Poors or its affiliates do not have the necessary licenses. All information provided by Standard & Poors is impersonal and not tailored to the needs of any person, entity or group of persons. Standard & Poors receives compensation in connection with licensing its indices to third parties. Any returns or performance provided within are for illustrative purposes only and do not demonstrate actual performance. Past performance is not a guarantee of future investment results. An index methodology involves rebalancings and maintenance that may be made periodically during each year and may not, therefore reflect real-time information. It is not possible to invest directly in an index. Exposure to an asset class is available through investable instruments based on an index. 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Practice Essentials | Income Investing 101

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