Retirement income: Where can you find income?

As recently as the beginning of 2012 there was hope that a recovering US economy would allow the Federal Reserve to start raising interest rates from the near-zero- percent level. This would be good for the millions of retirement and fixed-income investors who have been scrambling for the last few years to figure out a way to generate much-needed income. Well, after last Friday’s disappointing jobs report, both Goldman Sachs and Bank of America have said they think interest rates will be held at the same low level for the next three years, until the middle of 2015.

“The Fed, which has pledged to hold the rate low through at least late 2014, will amend its so-called forward guidance before deciding on a new round of bond purchases, according to the companies,” Bloomberg reported. It quoted Goldman Sachs chief economist Jan Hatzius as saying: “The ‘late 2014’ formulation has now ‘aged’ by six months since it was first adopted, but the economy still looks no better.”

This means fixed-income investors will need to stay creative to generate the income they need to achieve their retirement goals.

Higher income In last week’s column I mentioned that investors can use dividend-paying stocks to enhance their income. Many household names, such as like Procter & Gamble (PG), Johnson and Johnson (JNJ) and Coca Cola (KO), all have stocks that pay out higher dividends than their own corporate bonds. Not only do you get a 3 percent plus a dividend, you have the potential for capital appreciation as well. In addition, these firm have raised their dividends every year for decades.

But for some risk-averse investors the thought of investing in common stock is a bit much. They don’t want the stomach- turning swings in stock prices. I met with an older gentleman this week who told me that at his age, he is too old to own stocks and watch them drop by 30%-40%. He would rather make a very small return and keep his hard-earned principal intact, than potentially lose a good chunk of his net worth. Whether this is rational is not relevant. Many retirees are in a similar boat and feel the same way. What to do? Preferred stock Another solution for enhanced income, as part of a larger portfolio, is preferred stocks. Preferred stocks are like a hybrid between regular common stocks and bonds. Each share of preferred stock is normally paid a fixed, relatively high dividend, and in case of bankruptcy, it has priority over the common stock in terms of claims against a company’s assets. In exchange for the higher income and added safety, preferred shareholders miss out on potentially large capital gains.

How do they work? Many preferred stocks begin trading at $25 per share. For example, Company X issues a preferred stock at $25, with a coupon of 6%, meaning that every year the investor receives 6% on the amount he has invested, and this is usually paid quarterly.

Although this sounds very straightforward, there are also certain risks involved. Preferred stocks are considered to be like long-term bonds in the way they trade. As they can be quite volatile, this means the same preferred stock that started at $25 can end up trading much higher or lower than its issue price. In today’s low-interest-rate environment, many preferred stocks are trading well above par due to great demand for the high income.

If they can be so volatile, why would they be appropriate for risk-averse investors? The answer is because interest rates are likely to hold steady for the next three years. Outside of financial deterioration of the issuer, the major reason the price of a preferred stock would plummet is because interest rates are on the way up, and that doesn’t seem likely over the next few years.

How to invest? For do-it-yourself investors, quantumonline.com is a good resource to learn more about this asset class. There are also Exchange Traded Funds (ETFs) like the iShares S&P US Preferred Stock Index (PFF) or the PowerShares Financial Preferred (PGF), which both are currently yielding over 6.3%.

Additionally, investors can research individual issues such as a 6.1% General Electric Capital (GEC) or a 7% JP Morgan Capital (JPM PRJ).

It would take me another full column to discuss the various types of preferred stocks available: adjustable-rate preferred stock, convertible preferred stock, first preferred stock and participating preferred stock are just a few of the variations available. Speak to an adviser who can explain the various types, and then see whether preferred stocks would be good for your investment portfolio.

aaron@lighthousecapital.co.il Aaron Katsman is a licensed financial adviser in Israel and the United States who helps people with US investment accounts.