The US Federal Reserve has deployed low interest rates to help the economy recover from the pandemic’s effects. And it’s likely that these low rates will remain until at least the end of 2022.
While low interest rates stimulate spending, they also mean that your cash earns less interest in the bank. This interest is money you'd regularly earn just while keeping it in a savings account, making it a common type of passive income.
Given that cash in the bank is earning little to no interest for the foreseeable future, many investors have been asking us if there are any other ways to generate passive income.
The short answer is: yes!
Here are 3 ways you can generate passive income in a low interest rate environment:
When bank interest rates are low, many investors turn to bonds to receive regular coupon payments.
Because these payments are fixed upon bond issuance , many investors assume bonds are safer than stocks.
But, to get competitive returns on a bond, investors might choose high-yield bonds or even apply leverage to earn competitive returns on their investment. This approach can expose investors to certain risks.
So, if you’re deciding whether to invest in high-yield bonds, here’s what you should keep in mind:
Corporate bond issuers are companies, and like any company, they risk defaulting on their payments. For example, Evergrande Group, China's second-largest property developer by sales, offered a bond expiring in 2025 with a high yield of 15%. But, with the company at risk of defaulting on its debt, its bond price fell by more than 50% in mid-August from its average price since 2018.
Like equities, high-yield corporate bonds relate to the business results and health of the companies they represent. Historically, high-yield bond index drawdowns have been as high as 70% of equity drawdowns, indicating that a company's stock fluctuations can impact their bonds.
When interest rates rise, such as during times of inflation, bond prices drop, and vice versa.
This inverse relationship is particularly true for long-duration bonds. Because a long-duration bond's value primarily comes from its future coupon payouts, inflation and interest rate changes will affect them more. That’s because inflation erodes the value of future coupon payments. And as coupon payments are fixed, a bond’s price would be discounted to make the bond more appealing to investors. In short, as interest rates change over time, so will a long-duration bond’s value.
That means that long-dated government bonds can introduce volatility into your portfolio. For example, if you’d had the US 30 Year Treasury bond, you would’ve experienced corrections of up to 18% every 2 to 3 years.
Some stocks can pay out high dividends, but be careful with the risk they carry: after all, a company can still lose value.
Take, for example, HSBC stocks that yield 5% in dividend payments. This 5% may sound competitive in a low interest rate environment. But, HSBC's stock price has also fallen, and when you consider both the stock price and dividend returns, its total return stands at -33% in the past 13 years.
That's why it's important to pay attention to the company's fundamentals, and not only its stock dividends, to avoid losing your capital.
So high-yield bonds aren’t always reliable sources of income. And neither are dividend stocks. So what’s an investor to do? Diversify.
A diversified portfolio won’t always pay out consistent dividends or coupons, but if it’s diversified properly, it can also grow in value with capital appreciation and compounded returns. By considering the quality of bonds and stocks in a growth portfolio, you can increase the value your income investments can bring.
Here's an example of how StashAway's SRI 10% portfolio can create passive income. If you had invested consistently into this portfolio over the past 4 years, you would've generated annualised returns of 7.2% per annum. You could then stay invested to let your returns compound and grow. Or, you could cash out a portion of the returns periodically.
That way, your passive income won’t be dependent on the interest rate environment, which will always fluctuate depending on global and economic events. And if you decide to invest separately in stocks and bonds, just don't be too fixated on yield!
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