Investing for passive income has always been attractive to Hong Kong investors. And this is the reason why many of the blue-chip stocks listed on the Hong Kong Stock Exchange (HKEx) pay consistent dividends to cater to such demands.
Often, share prices are also heavily influenced by the ability to pay dividends. This was seen from the 14% surge of HSBC’s stock price in mid-2022 — after it announced the resumption of quarterly dividends from 2023.
But what are some other choices besides dividends if one is looking for passive income? What are the pros and cons of income investing? Let's start from the beginning.
What is income investing?
Income investing refers to investing in assets that can provide a constant stream of passive income. Such investments can be stocks that pay regular dividends — dubbed “income stocks” — or fixed-income instruments, such as government and corporate bonds.
With bonds, investors receive a fixed interest in the form of coupon payments, until the bond’s maturity date. Upon maturity, investors get back their principal amount. Learn more about bonds and bond funds here.
Other income investments include certificates of deposits and money market funds.
Who is income investing suitable for?
Income investing is particularly suitable for investors who have regular cash flow payout needs, such as paying down your monthly mortgage or your children’s monthly tuition fees.
Investors can usually be assured of more stable and predictable returns to fund such regular financial commitments and outlays.
Income investing vs growth investing
That being said, there is a common misconception in Hong Kong and around the world that income investing is only for retirees, those close to retirement, or investors with a lower risk appetite.
Indeed, growth stocks typically produce higher returns, through capital appreciation, over the long run as compared to income investments. But the discrepancy in returns may not actually be as large as we think, particularly with the extreme market volatility of recent years.
Due to the disparity of returns in the short term and the long term, income investing might be relevant for investors who need or prefer to receive cash payouts from their investments to fund their living expenses.
Data has also shown that passive income can also be an important source of returns. An investment portfolio typically has two sources of returns, which make up what is called the total investment return:
- Capital appreciation from any price increases in your holdings
- Regular income from stock dividends or bond coupon payments
Fidelity estimates that almost half of the total returns of the US market in the 30 years from 1988 to 2018 have come from dividend income.
So while some investors prefer to construct their portfolio to focus on capital appreciation or “growth”, others may prefer to focus on regular payouts or “income” when considering the portfolio’s total investment return.
Benefits of income investing
Regular, passive income
Income investing assures you of a steady stream of passive income. In fixed-income investing, companies or governments that issue bonds are legally bound to pay you bond interest or coupons. They must also repay your principal amounts when your bonds mature, unless they default or are under liquidation. This obligation means you can expect to receive the income even in bear markets.
Dividend stocks can also give you regular passive income. Dividends may come from a company’s yearly operating profits, which it shares with its shareholders. Note, however, that not all companies pay dividends, so not all stocks are dividend stocks. Also, companies are not obliged to declare dividends every year. They may cut or stop their payouts in a particular year if the economy or their business is not doing well. Recall that banks like HSBC and Standard Chartered cancelled their dividends in 2020 at the height of the Covid-19 pandemic.
In general, firms that are known for paying dividends have a history of making regular dividend payments. They tend to be more established businesses in more mature industries. These include banks, telecommunications, utilities, tobacco, food staples, essential goods, and real estate investment trusts (REITs).
Potentially lower volatility and risk
Income investments can help you create a more defensive and diversified portfolio that is better able to withstand market gyrations.
During bear markets, capital gains almost always disappear for stocks. However, as investors flee to safety, passive income investments such as bonds, especially US Treasury bonds, would provide you with some protection in your portfolio.
Some might point out the historic drops in both the fixed income and equity markets in 2022. Such simultaneous declines in both stocks and bonds was very much a rare event. Based on analysis by BlackRock, looking back at a 93-year span, from 1929-2022, there were only four instances when that has happened.
Risks of income investing
Interest-rate risk
Income investments may not be as affected by market declines, but they are certainly affected by interest rates. When interest rates rise, income investments tend to lose their value.
Bond prices and interest rates move inversely to each other. This is because as interest rates rise, investors will sell off their existing bonds in favour of new bonds that will be issued with higher coupon rates. We have all heard about the collapse of Silicon Valley Bank — interest rate risk mismanagement was a key contributing factor.
Inflation risk
Inflation is one of the primary risks for income investors. Although you are promised a fixed stream of payments through fixed income investing, these payments also likely remain at a fixed dollar amount, even if inflation rises.
Additionally, inflation diminishes the real value of your bonds' principal. Both factors create the risk of losing value on your investment, even as you collect payments and receive your principal back at maturity.
One way to deal with inflation risk is to invest in bond funds that have a mandate to invest in bonds or bond funds that are inflation-linked.
Default risk
The issuer of a corporate bond may default on its debt obligations, when it cannot make further interest and/or principal payments. In addition, bonds carry the risk of being downgraded by credit-rating agencies. This may affect their prices.
This can affect companies of a higher credit quality as well. Recent concerns regarding the debt crisis of Chinese developers show that even companies that used to be investment grade can face default risk, which makes diversification very important.
What are the best investment options to earn passive income in Hong Kong?
With proper planning, Hong Kong investors can use a mix of products to create their own streams of monthly passive income. The best way to approach this is to prepare a portfolio that is diversified across asset classes, countries and sectors.
Here are some building blocks to consider for such a portfolio:
Dividend-paying stocks and funds
Buying dividend stocks, or funds that are invested in stocks with a track record of paying regular dividends with good yields, is a common part of an income portfolio. Typically, larger, well-established companies are preferred for this. If you choose your stocks well, you can enjoy the best of both worlds: regular dividend cheques and capital gains if their stock prices rise.
For dividend-paying stocks and funds, these are the key terms you need to take note of:
Payout ratio
A company’s dividend payout ratio is the proportion of the earnings it pays out as dividends to its shareholders. This is typically expressed as a percentage. Whatever amount that is not paid out is retained by the company to pay off its debt or reinvest in its core operations.
Suppose that ABC decides to pay $1 dividend per share out of its $10 earnings in one year. Its payout ratio is 10%.
Dividend yield
The dividend yield of a stock is the amount of dividends a shareholder receives divided by the stock’s current price. Again, this is expressed as a percentage.
In the above example, if ABC is trading at $20 and pays $1 dividend per share, its dividend yield is 5%.
Fixed-income instruments and funds
Bond exchange-traded funds (ETFs) are available on the Hong Kong stock exchange, also known as HKEx. But fund sizes of these ETFs are generally small with low liquidity, and such ETFs are usually not diversified enough. A better alternative may be professionally-managed mutual funds (also known as unit trusts) that invest in income-producing assets — these give you immediate access to a diversified range of fixed income products. Some of these mutual funds can be hedged to local currencies, so that you do not take any foreign exchange risk with them.
Money market funds
Money market funds are also considered safe investments that can be used for monthly passive income.
They are short-term debt instruments issued by a government, bank or big company. They have short-term maturities of as little as a few days, or up to a year. Because of their short durations, they are typically considered risk-free, especially if they are from high-quality issuers.
The key disadvantage is that money market funds generate low yields in a low interest rate environment. However, with rising interest rates, money market funds have been generating historic high yields, at levels not seen in the past decade.
Real estate investments
Many Hong Kongers dream of owning multiple properties to enjoy monthly rental income streams. This, however, requires big upfront cash investments.
Other costs not often factored in by property investors in Hong Kong include maintenance, stamp duty and rates, income tax on property income, interest and management fees for the rental properties.
Also, real estate investments might have to be sold in much larger denominations.
Building your own passive income stream with Endowus funds
One of the key benefits of investing in unit trusts or mutual funds is the liquidity of the investments. You are able to sell off a portion of the investments and get the proceeds from the sale quickly.
One way to get a managed solution with multiple unit trusts is through the Endowus Passive Income model portfolios, which are suited for investors at different life stages. Read more about these model portfolios in our article.
Alternatively, you can also pick and choose from our curated list of top-rated funds to build your own income portfolio at a low cost. The table below highlights some of the income-focused funds you may consider. These funds are chosen for their robust levels of payouts and are backed by unique investment strategies.
Income funds on Endowus Fund Smart in Hong Kong
Invest in a cost-efficient way on Endowus, with our 100% Cashback on trailer fees and access to institutional share-class funds.
To get started with Endowus HK, click here.
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