In a bear market, it’s easier to generate more passive income

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While going through another bear market sucks, the positive is that we can all generate more passive income! And since we can now generate more passive income, we can also get a big step closer to financial freedom.

As a reminder, financial freedom means having enough residual income to cover your desired living expenses. When this happens, you can do whatever you want.

This bear market with its rising interest rates can certainly be a gift for investors. The key is not to get too depressed about the decline in the value of your portfolio because you have the right asset allocation. Eventually, portfolio values ​​will recover.

Another important component is maintaining your active income streams to take advantage of low asset prices. If you don’t have a guaranteed pension, retiring early and relying only on passive sources of income may not be the optimal strategy.

But even if you’re a traditional retiree with no active income, you should still see higher Social Security cost-of-living adjustments. Additionally, in an environment of higher interest rates, your income-generating investments can automatically generate more income.

Earn more passive income in a bear market

Like many investors, my net worth took a hit from the fall in stocks. At one point I had 30% of my net worth in stocks. A 25% drop in stocks pulls my net worth down ~7.5%. The most I lose in stocks is 10% of my net worth. After 10% my mood starts to get too sour.

But as a sham retiree, my primary focus is generating enough passive income to cover our desired living expenses. Seeing our net worth grow in a bull market is good for the ego. But the most important thing a retiree cares about is their cash flow, not their net worth.

Net worth is more of a subjective vanity metric. It’s good to calculate so you can see what kind of ROI you’re getting based on your exposure. It’s also good to keep track of your wealth for estate planning purposes.

But aside from those two reasons, cash flow is more important than net worth. Cash flow is real while net worth is subjective. My #1 financial goal is to generate enough investment income to support our desired lifestyle.

Higher interest rates mean more passive income

When interest rates rise, everything from bond yields to dividend yields tend to rise as well. The reason for this is that any return is relative to the risk-free return.

No sane investor would invest in a risky stock when they could earn a higher risk-free return. This should make it easier for investors to generate passive income when interest rates are higher.

Corporates that issue bonds need to increase their coupon payments to remain competitive with government bonds. Companies can also increase dividend payout ratios to increase stock dividend yields as well.

When it comes to real estate, cap rates need to increase to make real estate more attractive compared to the risk-free return. If rents don’t go up, house prices should adjust downwards. These are natural market forces at work.

In general, landlords are a big beneficiary of inflation as house prices and rents rise. Only the temporary increase in mortgage rates is too fast at the moment.

The crowding out of private capital due to higher interest rates

I used to regularly invest most of my cash flow in the S&P 500 and private real estate funds. On average, these two forms of investment generated investment returns of between 1.5% and 10%. In addition, the income generated is 100% passive.

However, with higher interest rates, government bonds are now crowding out private capital. Rather than investing my cash flow primarily in the S&P 500 and private real estate mutual funds, I have earmarked 60% of my money for buying ~4.5% yielding government bonds. Yes, 40 percent is still invested in risky assets, but that percentage was closer to 80 percent before interest rates shot up.

A guaranteed 4.5% yield on 1-3 year government bonds is attractive to those who rely on investment income to stay free. Government bond yields are particularly attractive compared to a ~1.8% dividend yield from the S&P 500, which is very volatile.

Real estate can easily yield more than 4.5%. However, there is also downside risk now as mortgage rates have skyrocketed. House prices could fall slightly by 5%-15% over the next 12-18 months if mortgage rates don’t fall over that period. Therefore, it is better to slow down the capital investment or bid more aggressively.

After all, some of the capital that may have flowed into growth stocks can now flow into higher-yielding bonds or higher-dividend-yielding stocks. In a bear market, a flight to safety often means higher residual income. A bear market also reminds you that cash flow is king!

Nominal yields are still good

Sure, your higher-yielding investments can still lose in real terms due to even higher inflation. However, making a nominal return is still better than actually losing money. And if you’re not losing money investing in a bear market, I’d like to know what you’re investing in.

Because of higher interest rates, this year I’ve been able to grow my total passive income portfolio by about 10%, or about $35,000. The gains came mainly from government bonds, private real estate investments and rental income.

As a sham retiree, I have cash flow from Financial Samurai and other writing-related activities that is reinvested in income-generating investments. I also have excess passive income that is being reinvested as we spend less than our current passive income amount.

Here are some ways I’m increasing passive income in this Fed-induced bear market.

Passive income soars in a bear market

  • So far I’ve invested $250,000 in government bonds, which will bring in an additional $11,250 a year. Before this year, government bond yields were not attractive.
  • Sunbelt’s rental income increases from about $50,000 (excluding distributions) to about $60,000 as higher mortgage rates push more people to rent. Check out Fundrise, my favorite platform for private real estate investing.
  • Net rental income from vacation homes in Lake Tahoe has increased from about $650 per month to an average of $1,500 per month net as COVID restrictions are lifted. We’ve been there twice this summer and the activity has been robust.
  • Increase in rental income from a property from $6,700 to $8,000 per month. About $300 of the rent increase was due to the market and $1,000 to a remodel that created an additional living room, bedroom, bathroom, laundry room, and closet. Tenants have agreed to a $200 rent increase next year.
  • Venture debt investing should generate higher returns because pricing is based on the risk-free rate plus a premium. I’m estimating an additional $3,000 to $5,000 in annual income this year from new investments.

Below are my estimated passive income streams for 2023. There will likely be a +/- 15% variance mainly due to distribution amounts from various private fund investments.

Financial Samurai Passive Income Estimate 2023

Maybe a bear market isn’t so bad after all

The income yield of your overall investment portfolio is likely to increase due to higher interest rates and a decline in the value of your portfolio. As long as the bear market doesn’t suffer much more than a 35% drop, we should be fine.

Of course, it’s a shame when the value of your portfolio falls. Retiring at the end of the cycle is terrible timing. But if you have cash flow, you can buy higher-yielding assets now. Therefore, a bear market will help you gain financial independence faster, or may increase your chances of staying in retirement.

Once a bull market returns, investment returns are likely to fall as asset prices rise. In such a scenario, you will still earn the same amount or more of passive investment income.

In other words, as long as you have a regular cash flow and things don’t get too bad, you always win! Even if you plan to retire, I encourage you to find ways to continually generate extra income for retirement.

The best supplementary retirement income is doing something you would do for free because it brings you joy and meaning. Financial Samurai will last for years because it’s still fun to operate. I’ll probably write more books before I die, too.

Switch to income-generating assets well before you retire

A bear market is a good reminder to switch some of your non-income-producing assets to income-producing assets years before you retire. After all, the only way to capitalize on growth stocks is through the occasional sale.

If you were expecting to switch to higher-yielding investments this year, then you’re obviously more disappointed. Therefore, it is probably wise to start transferring wealth three to five years before retirement.

A bear market is also a good reminder to always have some active sources of income so you can take advantage of low prices. Don’t just retire and do nothing. Retire and do something meaningful that also generates income. It doesn’t feel good to be 100% at the mercy of the market.

Income-generating assets not only tend to outperform during bear markets, they can sometimes produce even better returns during downturns. With proper asset allocation, you should be able to weather the storm until good times return.

questions and action items

Dear reader, are you finding your passive investment income increasing in this bear market? How do you plan to use higher interest rates to generate more passive income?

If you’re looking to surgically invest in real estate, take a look at Fundrise. Fundrise is a vertically integrated real estate platform investing primarily in Sunbelt single-family homes. Private real estate is a great way to 100% passively diversify and generate income.

If you want an unfair competitive advantage in building wealth, pick up a hard copy of my instant WSJ bestseller, Buy This, Not That. The book will help you build more passive income during a bear or bull market.

For more differentiated personal finance content, join over 50,000 others and sign up for the free Financial Samurai newsletter. Financial Samurai is one of the largest independent personal finance websites, launched in 2009.

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