Discovering Preferred Stocks

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Just when I think I can’t find another money subject to obsess over, I come across something really fun.  Of course, my fun comes in the form of interest and dividends. You know, passive income or getting money for no effort.

When browsing some financial websites, I came across a blog piece that featured how to live off of dividend income.  At the end of the article was a small, but not insignificant, mention of preferred stocks.  Well, now, hold on.  We’re not talking about 2%, we’re talking about 10 – 12% in passive income.  Preferred stocks pay a very high dividend that makes common stock dividends look like pocket change.  Wait, this is legal?

If preferred stocks aren’t in the news every day, …why not? No one has a silly acronym, like we have for the famous tech stocks, FANG. There must be some crazy risk associated with these investments and I began a search to understand this widget of preferreds and find out if there’s a downside.

For me, it always starts with books.  My two choices were Your Future Paychecks And Raises by John Roberts and A Preferrence For Preferreds by Michael Greco.

A future paycheck of passive income is critical to my retirement planning.  How else am I going to make money while sleeping late, reading books, and engaging in some leisure activity every day?  Both authors are sages of dividends, touting the benefits of the Dividend Aristocrats, dividend growth, and where to find these generous companies that shower their profits down on us.  Roberts advocates subscribing to two helpful newsletters, The Oxford Income Letter and The Daily Paycheck.  He’s big on a diversified portfolio.  All good, but it’s nothing that I didn’t know before.

What I still didn’t have was the answer to the mystery of the preferred stocks that was mentioned by the blogger that posted an annual enviable passive income of $52,000 in one year.

My next Kindle download was A Preferrence For Preferreds.  By magic, the holy grail of preferred stock was one fingertip tap away within seconds of my mouse click.  Gotta love Amazon.

I spent the remainder of the weekend reading A Preferrence and doing Google searches.  Here are some of the resources.

https://www.investopedia.com/articles/stocks/06/preferredstock.asp

https://www.investopedia.com/articles/active-trading/111114/preferred-stocks-versus-bonds-how-choose.asp

https://www.investopedia.com/advisor-network/articles/investing-preferred-stockthe-basics/

https://www.investopedia.com/stock-analysis/2011/prefer-dividends-why-not-look-at-preferred-stock-usb-tcb-tyy-wmt-c-bac-gs0411.aspx

From these articles and the book, I figured out the basics.  Preferred stocks are a two-faced instrument.  They are a bond that wants to be a stock.  They pay dividends at a state percentage, not interest, but have no voting rights.  They may be cumulative or non-cumulative, and are issued at a par value.  They may be perpetual or have a maturity date.  There’s no appreciation/growth and the issuer may call the investment.  The shareholder gets paid before common stock dividends are paid (that’s why it’s called preferred, get it?)

That doesn’t sound so bad.  Then… what’s the catch?

The catch is in default risk of the issuer, insolvency risk of the issuer, and credit risk, but, most importantly, interest rate risk.  Interest rates affect the value of the preferred stock just like a bond.  If the interest rate goes up, the value of the preferred stock goes down.

If you can swallow all that, you still have call risk, liquidity risk, reinvestment risk, and risk of principal loss.

OK, so one must tread carefully before venturing into the land of high returns.  Can some of those risks be mitigated?  Yes!

The financial wizards of the universe have created a playground where we can all hold hands together.

The retail version for normal people is in the form of Exchange Traded Funds (ETFs).  ETFs that invest in preferred stocks invest in 50 to 100 preferred issuances, reducing the investor’s default and credit risk.  It eliminates the liquidity problem.  If you want to get out, you can sell your ETF shares.  Now we’re talking.

In Jim Cramer’s Get Rich Carefully, he glorifies ETFs and their ability to capture a sector’s best performance while minimizing the direct risk of an individual stock.  ETFs have been embraced by institutional investors, and it’s a mistake to ignore that simple fact.

The marriage of preferred stocks and ETFs sounds like a match made in heaven.

A purchaser of an individual preferred stock issuance has too many things to worry about.  In A Preferrence for Preferreds, the author analyzes three investments down to their bare bones.  The investor has to understand the specifics of the issuance, the issuer’s business, if its perpetual or with a maturity date, if its cumulative or non-cumulative, and does it have a call stipulation?  What’s the yield and how does it fluctuate when the real-world interest rate changes?  Is it convertible and what’s the likelihood of a conversion?  What are the benefits and detriments of a conversion along the timeline of the ownership?  There are many moving parts and variables.

Whew!  Too many things to worry about!  All this and I have to worry about my life like getting an annual physical and a dental cleaning?  The holidays are coming, who has time to worry about all those unknowns?

I’ll take the ETF for $200, Alex.

With an actively managed ETF, the fund managers provide a low-cost (less than 1%) alternative to invest in high-income preferreds.  Because the fund is a basket, the return is not as high as the individual issuances.  You have to trade the risk associated with an 11% percent return for a 6% return with watered-down risks.  That’s a fair trade if you ask me.  Some recommendations to look into are PFXF and PGX.

But, wait, there’s more.

You could go for a Closed-End Fund (CEF).  A CEF is a fund that issues a finite number of shares.  CEFs are easy to purchase as the shares trade just like a regular stock.  The play with CEFs is getting the best price for the value.  The pricing works using the Net Asset Value (NAV) as the benchmark.  Pricing is at a premium or discount above or below the NAV.  Check out this resource:  www.cefa.com.

One of the indicated risks of both ETFs and CEFs is that the portfolio is always subject to change and the investor is at the mercy of the portfolio manager.  However, the upside is participating in the institutional space of an investment, which is not available to an individual investor.  People are so excited by ETFs and CEFs that they may offer options on the stock.

I don’t have the time to understand options, so I’ll stay on the mainstream path of buying shares.  That said, I scope out internet articles on these investments.  There’s always some writer out there comparing one against the other.  I value their opinion but what I combine that with is the reader comments on the comparison articles.  What I find is that there are real people out there that have owned the CEFs and how they feel about them.  That gives me some comfort that average people are investing and having a good experience (translation: making lots of money raking in passive income).

Based on the articles and reader comments, I narrowed my future toe-dipping down to two CEFs: ZTR and GPM.  If ZTR kicks out income the way it promises, at 13.72%, I will find a place for it in my Roth IRA where I won’t have to pay tax on the income.

Happy 2019 Roth IRA!

2 Replies to “Discovering Preferred Stocks”

  1. Love your blog. First time caller. My FA had discussed with me living off of dividend income and said that it was doable based upon my portfolio. I prefer this method instead of the 4% method. He didn’t specifically mention the preferred stock dividend income but maybe this is what he meant. We didn’t go into the details at the time but I will discuss with him more once I near full retirement. Great article!

    1. Hi Ken,

      Thanks for stopping by and for the kind feedback.
      Living off dividend income is reachable and realistic. Most people don’t realize that when their portfolio is concentrated in dividend-paying investments, it’s a much better option than the 4% withdrawal route. Why anyone would plan to reduce their assets on a continual basis is beyond me.
      I have a few preferred stocks, closed-end-funds, and ETFs on my To-Buy list.
      Happy Holidays!
      Dora

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