Your Investments: After the sell-off, look at preferred stocks for income

Fixed-income investors will need to stay creative to generate the income that they need to achieve their retirement goals.

By AARON KATSMAN
Dollar bills 370 (photo credit: Steve Marcus / Reuters)
Dollar bills 370
(photo credit: Steve Marcus / Reuters)
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. In fact, this past summer’s talk of a Fed “taper” sent yields on bonds spiking.
Then we received some very ho-hum economic data, and to calm markets the Fed basically retracted the taper talk and yields fell once again. With the disastrous rollout of ObamaCare, continued uncertainty of tax policy (i.e., more tax increases), weak GDP growth and most of the newly hired settling on part-time work, the US economic picture remains cloudy. Throw into the mix one of the biggest cheerleaders of the continued printing of money is now heading the Federal Reserve, and I wouldn’t get overly excited about rates moving up anytime soon.
This means fixed-income investors will need to stay creative to generate the income that they need to achieve their retirement goals.
Higher income I’ve previously said investors can use dividend-paying stocks to enhance their income. Many household names such as Procter & Gamble and Johnson and Johnson all have stocks that pay out higher dividends than their own corporate bonds. Not only do you get a 3%-plus dividend, you have the potential for capital appreciation as well. In addition, these firms have raised their dividends every year for several decades.
But for some risk-averse investors the thought of investing in common stock is a bit much for them. They don’t want the stomach-turning swings in stock prices. They would rather earn a very small return and keep their hard-earned principal intact than potentially lose a good chunk of their 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 stocks
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 large potential 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 that the same preferred stock that started at $25 can end up trading much higher or lower than its issue price.
A case in point happened this past summer. As talk of the taper heated up, preferred stocks got crushed. It was not uncommon to see falls of 10%-15% among some of the more popular issues. The iShares S&P US Preferred Stock Index dropped about 12% between May and August.
If they can be so volatile, why would they be appropriate for risk-averse investors? They may not be appropriate for everyone, but keep in mind that they have already been crushed, so investors are buying in at a discount; i.e., buy low and sell high. 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 foreseeable future.
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) such as the iShares S&P US Preferred Stock Index or the PowerShares Financial Preferred, which both are currently yielding in the 6% range.
Additionally, investors can research individual issues from the likes of Metlife or Goldman Sachs to name a few.
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.
The information contained in this article reflects the opinion of the author and not necessarily the opinion of Portfolio Resources Group, Inc. or its affiliates.
aaron@lighthousecapital.co.il
Aaron Katsman is a licensed financial adviser in Israel and the United States who helps people with US investment accounts. He is the author of the book Retirement GPS: How to Navigate Your Way to A Secure Financial Future with Global Investing.