The article was written by Samuel Rhee and was originally published on The Strait Times.
With inflation at multi-year highs, investors are on the hunt for regular streams of passive income to supplement their take-home pay. The most common choices are dividends from stocks and yield from fixed-income bonds, while some will swear on real estate and seek out rental income or try to hunt down inflation hedges. But there is an inherent risk that people may not initially see.
There are nuances behind the passive income strategies that require further due diligence. Not all investments that seem to provide an inflation hedge can deliver it in this environment of both slowing growth and high inflation. Passive income portfolio strategies that suit others may not suit you. Investing is a deeply personal endeavour.
Hunt for passive income
Core inflation in Singapore in June rose to 4.4 per cent, breaching 4 per cent for the first time since the end of 2008. Naturally, our first instinct is to find ways to protect and preserve our purchasing power and investors are already on the prowl for more income.
However, we are in a unique situation of not only higher inflation but also slowing global growth. The International Monetary Fund expects global growth to further slow from 3.2 per cent this year to 2.9 per cent next year. China’s economic slowdown is on investors’ minds while scorching inflation has been driven by cost pressures resulting from the persistent spread of Covid-19 around the world and the Russia-Ukraine war. With recession looming, simple inflation protection strategies may not always work.
For example, high-flying commodities did well in the early stages of inflation spiking but growth concerns have seen prices collapse in recent months. Often in this type of environment, investors pile into fixed-income bonds due to their relatively defensive qualities and the relative protection they provide over more volatile assets like stocks and commodities. To be clear, bonds have gone through several difficult months but the rout is largely behind us.
Rising interest rates and slowing growth probably warrant a second look at fixed income, especially if you are a long-term investor. In a rising interest rate environment, investors can buy bonds through a laddering strategy. This effectively allows investors to earn income from high-quality credit and use the income and money from maturing bonds to reinvest into fresh bonds that will pay a higher coupon.
With rising interest rates, you can generate better yield from similar or better-quality bonds without taking as much risk. Professional bond investors do this systematically and they can also use tools such as hedging to spread out risk and reduce cost.
Bond funds also allow for greater diversification benefits by giving investors exposure to hundreds of bonds from different countries and sectors, while managers are able to reinvest the proceeds from redeeming older bonds into new instruments with higher coupon rates or better prices.
Investment amounts in such unit trusts tend to be small enough to lower the hurdle for all retail investors, whereas a single corporate bond in Singapore is typically priced in a large denomination of at least $200,000 with costly transaction fees.
The other popular form of passive income is from dividends. IHS Markit data shows a projected 6.5 per cent growth in global dividend payouts this year. Investors have continued to pour money into dividend-linked funds because companies with a consistent dividend payout are meant to have defensive qualities. Large companies dominating with pricing power or the ones that are able to grow in an inflationary or slower growth environment stand out. Those who do well have a strong balance sheet to withstand the growth downturn while maintaining cash flow and keeping dividends stable. Because they do not need to borrow more, they are less affected by rising interest rates.
Again, being selective in this environment is key to securing steady passive income. As an example, both Singapore real estate investment trusts (S-Reits) and global Reits have been sold down amid inflationary pressures, rising interest rates and growth concerns. Reits are listed equities so when the market comes down, Reits will not be protected and will trade down together.
While they may have some defensive qualities like other dividend stocks, the sector may not do as well as some people think, especially if property prices also start coming off. Reits pay out distributions from collecting rental income and rely on both strong business activity in their specific real estate sectors and low operating costs to sustain distributions. The rapid rate hikes have hit Reits particularly hard due to the much higher interest costs. Past acquisitions were funded by cheap debt, so they will slow acquisition momentum.
Reits also face higher operating expenses for their portfolio assets due to inflation, so it is a double whammy. These may pressure some Reits to cut their distributions, especially those that did not adequately hedge their costs of borrowing to fixed rates or cannot improve their operational efficiency.
While physical real estate can potentially hedge against inflation when rents rise, similar to Reits, they will see higher interest and rents rarely keep pace with high inflation rates. Maintenance costs will also rise.
The Endowus Global Real Estate Portfolio – one of Endowus’ satellite portfolios that make up a core-satellite strategy – is invested in diverse global real estate and infrastructure companies, offering an effective hedge against inflation. It enjoys strong pricing power or even explicit long-term pricing contracts to pass the impact of rising prices to its customers.
Life stage matters
Individuals at different stages of life will have different financial priorities and goals. Retirees may prioritise more stable payouts to supplement their retirement income. But if you are part of the sandwich generation, you may be balancing more family expenditures while saving for retirement. Investors in this life stage can look for a balanced portfolio of long-term fixed income holdings and dividend-paying counters, such as the Endowus Income Portfolios managed by some of the leading global fund managers.
As for young investors, the earlier you start investing, the more time you have to grow and accumulate your wealth. Looking for passive income in this investing environment is no walk in the park. Rather than trying to find the best single stock or bond to buy, seek out diversified portfolios or funds, then commit to a regular investment plan through a dollar-cost averaging strategy. Sitting on your hands will only result in inflation eating quickly into the value of your money.
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