How to make passive income?

07 March 2023 by National Bank Direct Brokerage
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For many of us, the daily 9 to 5 work grind is how we make our income and support ourselves but there can be another way. For those of us who can’t count on a pension plan or income from a rental property, creating a stream of passive investment income can help secure our future.

It can also contribute additional cashflow during our working years to increase our overall income or provide a certain income support which can afford us the opportunity to pursue other interests. Depending on your individual investment objectives creating a passive investment income portfolio could be worth pursuing. Discover how to generate passive income with your investment strategy.

What is passive investment income?

Passive investment income is a recurring income that is generated from your investments and, in most cases, can be monthly or quarterly. The distinguishing factor is the regular income flow requires little to no daily effort to maintain.

The income can be generated from various types of securities (equity and fixed income) and can take the form of interest, dividends, or other types of distributions.

Even though the income is considered passive, an investor still needs to do their research to select the investments that will be part of the portfolio. It also goes without saying that a certain amount of time will need to be allocated by the investor to remain up to date on the underlying securities.

What are the different types of passive income investments?

A self-directed investor who wishes to create a traditional income producing portfolio will begin by searching for income producing investments. In general, dividend paying securities, Real Estate Investments Trusts (REITs) and bonds will be part of the solution.

Dividend stocks

When looking for cashflow, investors tend to gravitate towards dividend paying securities. The need or preference for a regular cashflow with the potential for future dividend hikes and share price increases makes these types of securities popular candidates.

Normally, only stable mature companies with reliable earnings will be able to maintain their dividend payments and increase them over time.

Traditionally, securities in the financial services, telecommunication and utilities sectors have been the go-to names for dividend investors. The reality is that dividend paying securities can be found in every sector and in different markets which allows the investor to build a diversified income generating portfolio. Most dividend paying securities have a quarterly payment that investors receive.

Find Investment ideas with Strategy Builder.

Real Estate Investment Trusts (REITs)

Another type of security that provides regular income that some readers might be familiar with are Real Estate Investment Trusts. As mentioned earlier not everyone can purchase a rental property but by purchasing a share or unit of a REIT an investor can own a slice of one by becoming a shareholder.

What are REITs?

They are companies that own, operate, or finance income-generating real estate, that, when publicly listed, trade like a stock. REITs can hold residential, commercial, and industrial properties or other revenue producing real estate.

When researching REITs, investors will notice that most tend to pay higher distributions (have a higher dividend yield) and a higher payout ratio than the typical dividend stock. There are tax reasons for this but also REITs require less retained earnings to fund their growth. Another consideration is that the dividend growth rate of most REITs will be lower than dividend paying stocks.

These companies usually have a stock symbol that ends in .UN and most will pay a distribution on a monthly basis, which can be desirable for investors needing monthly payments.

Bonds

A bond, or a fixed income security, is an investment that provides a return in the form of fixed periodic interest payments. They are usually semi-annually, and, at the end of the term, the principal amount is returned.

Investors can select bonds from one of the three levels of government or corporate bonds, the latter having a higher level of risk, but will also pay a higher interest rate.

In either case, the longer the term before the bonds maturity, the higher the interest rate will need to be for investors to be willing to purchase or hold onto the bonds. Bonds have historically been used to provide stability in clients' portfolios when the equity portion fluctuates and a dependable interest payment for investors.

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Learn how to purchase fixed income securities with NBDB in less than 5 minutes with this tutorial.

How to generate passive income with options?

Investors can use options to generate income on their stock and ETF holdings by writing (selling) calls and puts. If you’ve ever placed a buy limit order or sell limit order on a stock you’ve already done half the option transaction.

Some securities already pay a regular dividend and, by applying an option strategy, an investor can boost their income from that security. In other cases, by applying an option strategy, an investor can create a cashflow stream from a non-dividend paying security. Previously, investors could only sell the security or a portion of it to raise cash.

Although these strategies require a little more effort, once the transaction has been completed and the premium (income) received, the investor has to wait for the option to expire and hopefully rinse and repeat. Investors that have larger investment portfolios that hold multiple securities can take advantage of two income generating option strategies.

Covered calls

A covered call strategy involves selling a call option on a stock that gives the buyer of the call the right to sell your shares at a specific higher price within a certain time frame. The investor receives a premium (income) that they keep regardless of the outcome. If the higher price is reached or surpassed, the shares will be sold. If not, the option will expire which allows the investor to write another covered call if they desire.

One of the many advantages of a covered call is that it can be applied in all types of brokerage accounts (registered and non-registered), which in the case of a TFSA, creates a tax-free income source.

Cash secured puts

A cash secured put strategy involves selling a put option on a stock at the money or out of the money that will obligate the investor to purchase the stock at expiration if the price has been reached. This investor receives a premium (income) for selling (writing) the put option. This strategy can be used to generate extra income for the investor, if the option isn’t assigned then it can be repeated.

It can also be used to purchase a security at a lower price if assigned, because the premium received basically lowers the purchase price of the security. Please note this strategy is only available in a margin account and the investor needs to have liquidity (cash) on hand to cover the transaction.

How to generate passive income with Exchange Traded Funds?

Investors can use exchange traded funds (ETFs) to generate passive income by incorporating them into their portfolio. Regardless of the account size, ETFs can be an easy option to quickly build a properly diversified portfolio with an income focus. Within this space, investors have access to hundreds of ETFs with income or dividend focused mandates to choose from.

With an ETF, the investor is buying into the strategy and can benefit from the additional cashflow without having to select the securities, expiration date and strike price. Using ETFs takes the guesswork out of individual security selection and will provide the investor with a passive income stream with minimal effort after purchase. Depending on the ETF the distributions are made on a quarterly or monthly basis.

Make passive income with Fixed income ETFs

Instead of purchasing a few bonds an investor can purchase a fixed income ETF and indirectly hold dozens of bonds within the ETF. This reduces the concentration risk of having too few holdings, the same is true for dividend focused ETFs.

Covered call or cash secured put ETFs to have passive income investment

Investors can even purchase ETFs that provide a covered call or cash secured put strategy. One of the drawbacks of these strategies, when applied to individual holdings, for each call or put sold, the investor needs to hold 100 shares or have the cash available to purchase 100 shares.

How to generate extra income passively with securities lending?

The latest option for investors to generate additional income in their portfolios is by lending their fully paid securities lending program. This program can be applied to investors that hold a cash or a margin account that's not in a debit position.  Whether you are a buy and hold investor or trade occasionally you can lend your fully paid securities and earn extra passive income effortlessly. No need to be an experimented trader!

Fully paid securities lending program

The fully paid securities lending program allows investor to make their stock and ETF holdings available to be loaned out. In return, when securities are borrowed the investor will receive 50% of the extra income earned. The amount that can be earned will vary depending on the borrowing fee charged, the length of time the securities are borrowed, and the value of the shares loaned.

Varied passive income sources for investors!

Self-directed investors looking to generate passive income with their investment portfolio have never had it easier with such varied selection of investment products. Using the different tools and research that their online broker provides they can create a portfolio that pays out a regular income.  From stocks, Reits, bonds, options, ETFs and a fully paid securities lending program clients can achieve their investment objectives.

Key takeaways :

  • Passive investment income can be generated by investing in dividend-paying securities, real estate investment trusts (REITs), and bonds.
  • Covered call and cash secured put options strategies can help investors generate passive income.
  • Fully-paid securities lending is a simple solution to generate passive income without additional effort or investment.

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