This is one of the safest ways to earn income in this crazy market
From Dr. David Eifrig, MD, MBA, Editor, Income Intelligence:
Before we get started, I must admit… It’s one of the most boring sectors of the market.
You probably won’t be bragging about it at the summer barbecue or your company’s water cooler…
If everyone purchased this type of investment, the financial news channels would die. Headlines would get a bit less shrill. And people would mostly ignore CNBC’s latest “hot take” on the market…
But most people would also enjoy better returns and have greater diversification. Rather than selling at bottoms and buying at peaks, investors would ride the inevitable waves and earn a fat return over the years.
You see, the advantage to investing in this sector isn’t just that it’s safe… or nearly unknown outside of a group of select Wall Street “insiders”… It also returns a higher yield than nearly any other safe investment you could make today.
In other words, this investment is a powerful tool for income investors that’s right at the intersection of yield and safety.
Today, I’m detailing the opportunity in what’s known as preferred shares (or “preferreds”)… the hybrid blend between bonds and stocks.
Based on the benchmark S&P U.S. Preferred Stock Index, preferreds offer an average yield of 6.24%. That’s a huge payout in today’s low-rate world. That yield is also safer than traditional dividends.
Preferreds are able to do this because they are fundamentally different than other securities… Here’s how a preferred share works…
If a company needs to raise $100 million in capital it could do this several ways:
- It could sell shares of common stock. That would dilute each shareholder’s ownership, but the company wouldn’t have to make regular payments, unless it chose to pay dividends.
- It could borrow the money by issuing bonds. It would have to pay interest along the way, and pay back the bonds at maturity.
- Or, it could issue preferred shares. Unlike a common stock dividend, the dividend rate on preferreds is specified in the contract.
The company could sell four million preferred shares at $25 each, collect $100 million, and agree to pay a dividend rate of, say 5%, in quarterly installments.
Now, the preferred dividend isn’t guaranteed (and neither are common stock dividends). If the company runs into financial trouble, it can choose to suspend its preferred dividends. However, it can’t pay a single penny in dividends on its regular common stock unless it keeps paying dividends on its preferred shares. Many preferred shares are also “cumulative,” meaning that if the dividend is suspended for a few quarters, that tally keeps adding up and it must all be paid back when the company starts paying a dividend again.
Preferred shares are typically issued as “perpetual” preferreds, meaning that they will go on paying that dividend rate indefinitely. Though like a bond, if the market price of a preferred share is higher than its issue price, a new buyer would earn a lower yield than the original rate. Other preferred shares are “callable,” meaning the company can buy them back at a set price after a specific date in the future.
So as a practical matter, preferred shares’ dividends are much safer than regular dividends. And there are some additional benefits to preferreds…
The way to build a safer and more profitable portfolio is by combining uncorrelated assets. For example, stocks and bonds don’t move perfectly together. When you combine them, you can earn a better return relative to your risk.
When investments move perfectly together, they have a correlation of 1.0; and if they bear no relation to each other, they have a correlation of 0. As you add more uncorrelated assets, you make a portfolio stronger and stronger.
Preferreds, in particular, are in a class of their own. Preferreds have only a 50% correlation with stocks and are even less correlated with the bond market.
The closest correlation with preferreds are investment-grade corporate bonds. That makes sense. Preferred shares are high-quality, safe investments that pay regular income flows, just like good bonds.
By adding preferreds to your portfolio, you’ve utilized an entire new asset class, making your portfolio more resilient to volatility.
On top of that, the dividends paid by preferred shares are often considered “qualified dividend income.” This means that they are taxed at the lower capital-gains rate, rather than as income. It depends on your income level, but if you’re in the 25% tax bracket, you’ll pay 25% on interest income from bonds, but only 15% on qualified dividends from preferreds. That means collecting $1 from a preferred is the equivalent of collecting $1.13 from a bond.
Preferreds have improving financials, rising stock prices, and more potential upside than bonds if a company does well.
At the same time, the income stream of preferreds is more dependable and fixed, like bonds. It also has a better claim on assets in the rare case of bankruptcy. If a company goes bankrupt, bondholders get to take what they are owed from the assets. After that, preferred shareholders take what they are owed.
Investing in individual preferred shares is relatively simple – most preferreds trade over the major exchanges and are easily accessible through your broker.
For investors looking for short-term capital gains, preferred shares don’t make for the best investment. But the opportunity for an income investor should be clear. High yields paired with safety are exactly what I look for in Income Intelligence.
Here’s to our health, wealth, and a great retirement,
Dr. David Eifrig
P.S. In today’s issue of Income Intelligence, I am recommending three individual preferred stocks that can safely return as much as 6% each year — regardless of what the broad market does. You can get immediate access by signing up for a risk-free trial subscription right here.