Bonds and dividend-paying stocks can supplement your income.
Receive passive income from CDs, bonds, and dividend-paying stocks
Can laddering bonds and living on the interest payments make you as successful as internet gurus (and great guys) like Pat Flynn and Tim Ferriss? I had the opportunity to interview Smart Passive Income’s brilliant, charming and hard working founder, Pat Flynn on my radio show, Goldstein on Gelt. I’ve also read – and really enjoyed – Tim Ferriss’s book, The Four Hour Workweek. They are both inspiring and creative. On top of that, they have developed passive income streams by using the internet to reach a huge market.
Can you have passive income if you don’t know how (or don’t want) to make a website?
If you don’t want to sell things online, don’t worry. You can earn dividends on stocks and interest on bonds and receive regular income. The fundamental difference between the Flynn/Ferriss model and the investment model is what you have to start with. The main asset for those guys is themselves. They started with some good ideas and built online businesses around them. If you want to live on interest and dividends, the asset you need to stat with is money.
Naturally, not everyone has the nest egg required to inaugurate their investment portfolio. However, if you’ve been tucking your excess cash into low-yielding savings and checking accounts, it’s time to learn about fixed-income strategies that might help you increase your income.
“I like to always keep $250,000 in my checking account,” an elderly client told me a while ago. Frankly, I was a little surprised. Who really needs that much liquidity? Though everyone needs an emergency fund of at least three to six-months worth of spending, beyond that, you should consider using investments. I put together an investment plan and showed her some of the different income-producing investments that might fit her needs and tolerance for risk. We looked at:
Corporate bonds – A corporate bond is a loan that you make to a company. They agree to pay you regular interest payments (usually once every six months) and to repay the loan at the end. If you buy several different bonds from different companies, those semi-annual payments may come in at different times of the year and provide you with an income stream. You can diversify by not only buying bonds from different companies, but also by buying bonds that have different maturity years. For example, you might buy a one-year, two-year, and three-year bond. Then you’d have principal coming due each year. If you don’t need the money then, you can use it to buy another bond, extending your ladder further. Financial advisors frequently recommend laddering bonds to their clients.
Risks of bonds – When advisors talk to their clients about bonds, there are a number of risks that they often mention including:
Interest rate risk – If you buy a bond that is paying 4% and try to sell it later if interest rates have gone up to 6%, who would want to buy your 4% bond? If the market is offering 6%, then the 4% bond no longer looks so attractive and you will not be able to sell it for what you paid.
Reinvestment risk – Let’s say you bought an 8% bond that matured in five years. When the bond matures, presuming you don’t need the money, you might want to reinvest. But if rates have dropped to 2%, you will not be able to get the 8% like you were used to. To put some perspective on this, consider what would happen if you had had a $100,000 bond paying 8% ($8000 per year). If you have to reinvest that money at 2% ($2000 per year), you will find yourself short $6000 every year. That’s a lot of money.
Inflation risk – If you have a bond that pays 2% and inflation is 3%, you’re behind the eight-ball. You are actually losing spending power, which is very much like losing money (even if you still have the same number of dollars).
Credit risk (a.k.a. default risk) – When you lend money to a company, they owe you the money. But what happens if they go out of business? You could lose your whole investment. Normally, it doesn’t happen. But it could, and you need to be aware of that. And anyway, as we always say, past performance is not necessarily an indication of future returns.
Including CDs as part of a portfolio
My $250,000 money-squirreling client was OK with some level of risk, so she bought some corporate bonds. However, she also wanted part of her money with more safety, so we bought FDIC-insured Certificates of Deposit (CDs). I reminded her, though, that even CDs have risk, including interest rate risk, reinvestment risk, inflation risk, currency risk, and more. Nonetheless, in certain ways they act like corporate bonds, so she’s able to diversify amongst different banks and maturity lengths.
Many companies that trade on the stock exchange pay a quarterly dividend. Sometimes that dividend can be 4% or more, which may sound attractive. In the case of this client, though, we did not explore that possibility because she did not want the added risk of owning stocks. For a lot of people stocks make sense, but for most people, they may not. In her case, regardless of the income the stocks might have produced, being more conservative was higher up on her list of priorities.
Disclaimer: This article is for educational purposes and is not a substitute for investment advice that takes into account each individual’s special position and needs. Past performance is no guarantee of future returns.