A natural gravitational pull occurs when the subject turns to income investing.
Dividend stocks exert the most pull, followed by REITs and MLPs. Bonds are at best a tertiary tug because of low interest rates.
That dividend stocks should exert the most pull is understandable. Stocks are liquid. Negligible brokerage fees mean stocks are cheap to buy and sell. Of course, many offer income to boot.
I’m hardly immune to the pull. Dividend stocks lead the income brigade across most of the income platforms under my purview. They lead for good reasons: Many produce immediate high-yield income. Many produce high-yield income and price appreciation over time.
When I refer to dividend stocks, I usually refer to dividend common stocks. Another class of dividend stocks exists. It’s a class I recently added to one of our income services. Dividend preferred stocks are the new addition.
Most income investors overlook preferred stocks. That they overlook is understandable.
The preferred stock market is small. The market value of U.S. preferred stocks is roughly $240 billion. That’s a considerable amount in absolute terms. It’s a pittance in relative terms. The preferred-stock market is roughly 1% the size of the U.S. equity market.
Good things can come in small packages. They can come in small markets.
Preferred stocks are a good thing from the income investor’s perceptive. I offer five reasons why preferred stocks can be a good thing.
- High Yield – Most preferred stocks yield above 6%. What’s more, the payment is resolute. The payment is contractual and is stated as a percentage of par value (usually $25).
- Safety – Preferred stocks have a higher claim on earnings and assets than common stocks. Preferred dividends must be paid before common-stock dividends.
- Low Volatility – Because of their bond-like qualities, preferred stocks are usually less volatile than their common stock counterparts. The higher quality preferreds are analogous to bonds; therefore, they can lower overall portfolio volatility while increasing portfolio yield.
- Tax Efficiency – Preferred stocks can be more tax-efficient than bonds. Interest paid by bonds is taxed at your marginal income tax rate. Qualified dividends are taxed at a maximum rate of 23.8%. Many preferred stocks pay qualified dividends.
- Liquidity – Preferred stocks trade on the major exchanges like common stocks, real estate investment trusts, and bond funds.
Carry trade is another reason to like preferred stocks. Carry trade refers to borrowing at a low short-term rate and investing the proceeds at a higher long-term rate. Preferred stocks avail themselves to a carry-trade strategy.
A proper carry-trade strategy can safely boost yield by 25% or more. The following example highlights the added income and yield carry-trade leverage can provide.
|Borrowing 30% of Equity at 1.5%||$300||N/A|
|Annual Preferred Dividends @ 6%||$78||$60|
|Less: Annual Interest Cost at 1.5%||($4.50)||N/A|
|Net Cash Received Dividends||$73.50||$60|
|Yield on Equity Investment||7.35%||6.0%|
Leveraging a single investment is risky; I recommend against it. Borrowing cost is another. Individual investors are unable to borrow as cheaply as institutional investors.
To gain the advantages of preferred stocks, as well as low leverage costs and diversification, consider a leveraged preferred closed-end fund (CEF). These CEFs trade like individual preferred stocks on the major stocks exchanges.
The CEF structure offers another advantage: The underlying portfolio can be bought at a discount to net asset value.
I recently added a leveraged preferred CEF to the Millionaire’s Retirement Club recommendation list.
This particular CEF yields 7.2%. It’s well diversified across issues (many only available to institutional investors) and geography. It also pays income monthly instead of quarterly.
I recommended this preferred-stock CEF at an 8.1% discount to NAV. A dollar’s worth of assets was bought for less than 92 cents.
Few investors avail themselves to preferred stocks. Fewer avail themselves to preferred stocks through a CEF.
Preferred stocks offer high-yield income. Preferred stocks bought through a CEFs offer the opportunity to collect 4X more income than common dividend stocks. They offer the opportunity to buy income investments (that cover the spectrum) at discounts of 20% or more to market value.
Click here to learn how to collect your next high-yield income at a discount to market value.