Making money from financial investments is the truest form of passive income there is, in my view. Passive income means earnings generated with minimal effort, such as with dividends from shares or interest from bonds.
The only real effort involved is picking the right share or bond in the first place and then monitoring its progress periodically.
Much excitement has been seen recently from a spike in UK government bond yields. Those yields have jumped to around 4.7% on the benchmark 10-year bond, known as the ‘risk-free rate’.
As I have large holdings of these, I am as happy as the next bondholder. However, this does not mean that I will be moving all my money currently in stocks into these.
Shares chosen for their passive income potential can generate much greater returns than UK government bonds even now.
Three qualities I want in passive income stocks
The first thing I want in passive income stocks is a yield significantly higher than the 10-year UK government bond. As a stock’s yield moves in the opposite direction to its price, this will change frequently.
The second quality I look for is that a share seems very undervalued to me. This reduces the chance of my making a loss on the stock should I ever wish to sell it. This would effectively diminish the overall passive income I had made on the share.
And the third element I require is that the business is strong enough to keep paying the high dividends.
A prime example of these factors at play
On the first element, I bought HSBC (LSE: HSBA) shares when they yielded well over 7%. As the share price has soared since then, the yield has gone down to 5.9% now. That said, this has been more than compensated for by gains in the stock price if I wished to sell them.
On the second, a discounted cash flow analysis shows the shares are technically 55% undervalued, even after their rise. Given their present £8.24 price, the fair value for them would be £18.31. Market vagaries might push them lower or higher than that, but they still look full of value to me.
And finally on business strength, a risk is that the recent decline in UK interest rates will reduce its net interest income. This is the difference between a bank’s income from interest charged on loans and paid out on deposits.
However, HSBC has shifted its strategy from interest-based to fee-based income. This resulted in Q3’s pre-tax profit rising 9.9% to $8.48bn (£6.95bn), way ahead of analysts’ consensus of $7.6bn.
How much passive income can be made?
Investors considering a £10,000 stake in HSBC would make £8,014 in dividends after 10 years. And after 30 years, this would have risen to £48,454.
By then, the total HSBC holding would be worth £58,454, which would pay an annual passive income of £3,449.
This is based on ‘dividend compounding’ being used and on an average 5.9% yield over the periods. Analysts forecast the yield will rise to 6.7% in 2025, 6.9% in 2026, and 7% in 2027 but there is no guarantee it will.
Given that all three factors that led me to buy in the first place are still in play, I will be buying more HSBC shares very soon.
This post was originally published on Motley Fool
