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How I’d aim for passive income of 7% to 13% a year from FTSE 100 shares

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macro shot of computer monitor with FTSE 100 stock market data in trading application
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When discussing investing with youngsters, they tend to fall into two categories. Group #1 aims to get rich quick, perhaps from one big score. Alas, this attitude is more suited to bank robbers and casino gamblers than true investors! Group #2 want to enjoy life with a passive income (unearned income regularly rolling in). For example, these earnings might be come from cash interest, bond coupons, property rents and share dividends. But with interest rates at record lows, generating passive income is tricky nowadays. That’s why I rely on cheap shares in the FTSE 100 index to generate extra earnings.

The FTSE 100 pays nearly 4% a year in cash

To me, the FTSE 100 is undervalued today, both in historical terms and when compared to other assets. Currently, the Footsie trades on a forecast 2021 price-to-earnings ratio of 14.9 and an earnings yield of 6.7%. It also offers a forecast 2021 dividend yield of 3.8% a year. In other words, if I buy the entire FTSE 100 — say, through a low-cost tracker fund — I can expect a yearly dividend income of nearly 4%. Of course, this being the average dividend yield, many FTSE 100 shares offer much higher cash yields than this average.

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Cheap FTSE 100 shares can pay big dividends

I asked analysts at investment platform A J Bell to find the 10 shares offering the highest FTSE 100 dividend yields today. Here are these high-yielding shares:

  Company

Dividend

yield (%)

Dividend

cover (x)

Payout

ratio (%)

1 Rio Tinto 13.1% 1.31 x 77%
2 BHP Group 9.6% 1.03 x 97%
3 Imperial Brands 9.0% 1.67 x 60%
4 Evraz 9.0% 2.19 x 46%
5 M&G 8.8% 1.26 x 80%
6 Persimmon 8.1% 1.03 x 98%
7 Phoenix Group 7.7% 0.63 x 160%
8 British American Tobacco 7.7% 1.39 x 72%
9 Polymetal 7.4% 1.49 x 67%
10 Legal & General 6.9% 1.68 x 60%

Source: A J Bell, 03/09/21

As you can see, these 10 FTSE 100 stocks offer dividend yields ranging from almost 7% a year to a whopping 13%+. The average dividend yield across all 10 is 8.7% a year. Thus, were I to invest £1,000 into each of these 10 shares (totalling £10,000), I should receive a passive income of £870 a year in cash. That’s far, far more than what I might earn from cash deposits or safe government bonds.

Now for the bad news…

Here’s the main problem with relying on share dividends for passive income. They’re not guaranteed, so they can be cut, suspended or cancelled at any time. Indeed, during 2020’s Covid-19 crisis, hundreds of UK-listed companies — include dozens of FTSE 100 firms — slashed their cash payments. Another problem with dividends is that not being guaranteed means they aren’t as reliable and safe as, say, cash interest or bond coupons. But I deal with this uncertainty by diversifying: spreading my risk across many companies to widen my dividend base.

Then again, I would never build a portfolio solely from these 10 high-yielding FTSE 100 shares. First, because there wouldn’t be enough diversification across market sectors. This list contains four mining groups (Rio Tinto, BHP Group, Evraz and Polymetal), three financial stocks (M&G, Phoenix Group and L&G), two tobacco companies (Imperial Brands and British American Tobacco) and housebuilder Persimmon. That’s too narrow a base and too concentrated a portfolio.

Lastly, a couple of these firms pay out a high proportion of their earnings in dividends. Dividend cover of 0.63 times at Phoenix and 1.03 times at BHP suggest these yields might be stretched a bit thin. Even so, I’d still rather rely on share dividends for my passive income than ultra-low-yielding cash or bonds!

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Cliffdarcy has no position in any of the shares mentioned. The Motley Fool UK has recommended British American Tobacco and Imperial Brands. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services, such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool, we believe that considering a diverse range of insights makes us better investors.

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