Obtaining a passive income has become more difficult over the past few months, as a number of shares have cut their dividends. There may be further changes to dividend policies should another market crash occur later in the year, thereby making the task of generating an income return on your capital even more challenging.
However, by focusing on defensive shares with affordable dividends, you could build a resilient portfolio that offers a reliable long-term passive income.
Defensive shares
Some companies have been negatively impacted by the recent market crash and the uncertain outlook for the economy. Others, meanwhile, continue to offer an attractive passive income due to their business models being relatively defensive. In other words, they are less reliant on the economy's outlook than their share market peers.
As such, it may be prudent to purchase companies with defensive characteristics during a market crash. They may be less likely to cut or postpone their dividends, and may even be able to raise shareholder payouts to provide a growing passive income over the long run.
An affordable passive income
Companies that pay affordable dividends may also offer a more resilient passive income during periods of economic strain. A business that uses a modest portion of its net profit to pay dividends may not need to reduce its shareholder payouts in a scenario where its profitability comes under pressure.
Therefore, focusing your capital on companies with attractive dividend coverage ratios could be a shrewd move. The dividend coverage ratio is calculated by dividing net profit by dividends paid, with a figure in excess of 1 showing that profits fully covered shareholder payouts. However, to obtain a more secure dividend, investors may wish to purchase companies that have dividend coverage ratios that are in excess of one so as to enjoy a margin of safety.
Spreading the risk
Obtaining a passive income from a wide range of assets was possible prior to the global financial crisis. However, low-interest rates since then mean that the income returns on cash and bonds have been disappointing. They now look set to remain low over the coming years to support economic recovery.
Therefore, diversifying across a range of dividend shares is likely to become increasingly important. Investors may have a larger proportion of their portfolio in equities, which poses greater risks than having a mix of income-producing assets that includes cash and bonds.
Through buying multiple shares to create a passive income, you can lower your company-specific risk. This is the risk that one or more companies experience disappointing periods that have a large impact on your portfolio's overall performance. By spreading your capital across many businesses, it is possible to enjoy a more reliable income over the coming years – even if there is a further market crash.
