PFFA - 3 Preferred Stocks To Own For Your Retirement Yields Up To 8.8%

2023-11-13 07:35:00 ET

Summary

• Preferred stocks offer higher yields and greater income reliability.
• Today, we will discuss preferred stocks in general for those of you who are new to them, or for the old hands who might need a refresher.
• Higher interest rates have created a buying opportunity for preferred securities, and we provide a few picks to maximize your retirement income.

Co-authored with "Hidden Opportunities"

Amidst rising interest rates, we have been recommending at least 40% allocation to fixed-income securities, and this can be achieved through bond funds, preferred stocks, and baby bonds. These can be much safer investments than stocks, and offer solid preferred income with lower price volatility than stocks. With these instruments, you pay a specific price to lock in a fixed yield. Even if the price fluctuates, your income under most circumstances remains the same. This is why we insist on building a rate-agnostic portfolio. The Fed may occasionally move rates up and down, but our retirement income must be set on our terms.

In a recession, investors get scared, and fear drives them to safety. Preferreds and baby bonds are financial instruments sitting higher up on the corporate capital structure, making them more immune to everyday sentiment around the company and its near-term economic outlook. For example, the preferred of a company aren't going to be impacted by a regulatory fine, higher CapEx in the next two quarters, or other strains on profitability. Preferreds share the characteristics of stocks and bonds, frequently offering higher yields than both.

As such, a mild recession would have no significant effect on the preferred dividend payability, as seen on several occasions in the past. In fact, several prominent U.S. banks continued paying preferred dividends despite cutting or suspending their common dividends. This is why I am personally loading up on preferred stocks!

Basic Facts About Preferred Securities

1. Preferred securities pay dividends, not interest: Traditional preferreds pay dividends rather than interest income, and in periods of severe stress, the issuer can skip a payment without triggering a default. Income earned from preferreds can be taxed in a manner similar to the taxation on common stock dividends.

2. Multiple Rate Structures: Preferreds can have fixed, floating, or fixed-to-floating rate dividends. Floating rate structures offer significantly less interest rate risk than fixed-rate securities.

3. Ranking above common stock: Preferreds rank lower than senior debt and higher than common equity. That means, in the event of an issuer's default, investors holding that company's preferreds will get paid back after the bondholders and before the stockholders. All cumulative preferred dividends must be paid before any dividends can be paid on the common shares. Source

4. Cumulative & non-cumulative: Most preferred securities issued by financial sector ('FS') companies (such as banks and insurance companies) are non-cumulative, meaning a missed dividend is not accrued and is not mandatory to pay in full before releasing funds towards common stock dividends. This is not a disadvantage. For a preferred investor, a common dividend doesn't benefit us in any way. Whether management pays themselves hefty salaries, throws the money from the roof, or pays common stock dividends, it makes no difference to us. It is purely a psychological safety net where preferred shareholders feel they will get paid as long as the common dividends are intact.

FS companies have regulatory capital levels, and the cumulative nature of preferred dividends creates a challenging headwind on the company's regulated metrics. But in reality, banks issue a significant proportion of preferreds, and the banking sector historically has a lower preferred default rate than other sectors. From 1983 to 2016, the default rate of the banking sector preferreds averaged 0.5%, while all other sectors averaged 2.3% (Source: Moody's).

Most non-FS companies issue cumulative preferreds, allowing missed dividends to be accrued and paid in full when the payments resume.

5. Maturity Terms: Preferred securities can be terminal and mature at a set date during which they are redeemed by the issuing company at par value (or as described in the prospectus). These are typically less volatile and can be significantly insensitive to interest rates if the maturity date is in the next 24 months.

Most preferreds are perpetual. This means they have a call date, but the company is not mandated (but has the option) to redeem after that date. Perpetual preferreds are, as the name suggests, endless sources of income and your best friend when purchased at discounted prices. Since redemption can be "never," these are very sensitive to interest rates. Terms and conditions of the security's dividend can change if it trades post-call date - for example, some fixed-rate preferreds can become floating-rate structures.

Let's Talk About Price Volatility

Preferred securities are less correlated with the everyday expectations of Mr. Market on their business execution and competitive landscape. However, they are vulnerable to interest rate changes. When interest rates rise, there are "guaranteed" alternatives for income, making preferreds less in demand. As such, they experience price drops. However, as long as the issuer is in good standing, dividends keep flowing, and prices recover when rates are lowered. Let us review the 20-year history of preferred stock performance. Source

As seen from the table above, monetary policy affects preferred stock prices, but only temporarily and on the surface. We see volatility, but as an income investor, volatility is your friend.

Let's examine iShares Preferred and Income Securities ETF ( PFF ), which is diversified across 455 preferred securities from U.S. companies. A $10,000 investment in PFF in 2008 (before GFC) would currently be worth over $19,000 but would have seen a maximum drawdown of -54.40% in 2009. At the time, it would only be worth $5,000, but that is only if you sold it. Preferred stocks are more valuable when held through drawdowns than if sold in fear of those drops. Source

The value of such an investment is the income it generates for us, not what Mr. Market will pay to buy it from us. PFF generated reliable income through the most significant financial crisis in modern times and a global pandemic that corporate America has never experienced in its existence. Shareholders would have collected $14,227 in dividends (an 8.9% annual average yield).

So when prices of such a basket of preferreds drop, buying more and collecting a sizable waiting fee is almost a no-brainer. We buy our preferred to hold until maturity or redemption. Capital gains are great, but we don't depend on it for our well-being. If the preferred is perpetual, we intend to hold for as long as the investment suits our income requirements.

Opportunities Available Today

In simple words, the opportunities are abundant as the monetary policy remains restrictive. But interest rates are not going to stay elevated forever, and the preferreds today offer not just massive dividend yields, but due to their double-digit discount to par value, they are very likely to offer substantial capital upside over time. High secure dividends, capital gains, and tax advantages are a fantastic trifecta for income investors, and this is a generational buying opportunity.

We haven't seen these kinds of yields for more than a decade - Eric Chadwick, President of Flaherty & Crumrine

Here are a few worthy picks:

1. Huntington Bank Preferreds - Yield up to 7.4%

Huntington Bancshares Inc. ( HBAN ) is a well-managed banking institution with a highly conservative investment portfolio, strong liquidity and capitalization levels. The 26th largest bank in the U.S. maintains a growing common dividend at a modest payout ratio. We like its deeply discounted preferreds:

• 4.50% Series H, Fixed-rate, Non-Cumulative Perpetual Preferred ( HBANP )

• 5.70% Series I, Fixed-rate, Non-Cumulative Perpetual Preferred ( HBANM )

HBANP in particular offers a 6.8% qualified yield and 51% upside to par.

2. Energy Transfer Preferred - Yield 8.8%

The hydrocarbon industry is going through massive M&A activity, and midstream is an active component of large deals. Consider the recent Crestwood ( CEQP ) acquisition by Energy Transfer Partners ( ET ), and the issue of ET preferreds in exchange for the Crestwood Preferred Partnership Units.

The new ET-I , Energy Transfer LP, Series I, Cumulative Perpetual Preferred Units, cannot be called, and it is still superior to any other preferred from ET or most other companies. You can lock in a healthy ~9% yield knowing you'll get that yield on your capital indefinitely. (ET-I issues a K-1 tax form)

3. RPT Realty Preferred - Yield 7.1%

REITs are also experiencing massive consolidation as a result of generational market mispricing against their fundamentals. We are hearing large M&A deals being announced every day, and the safety of several preferreds is improving as a result of an acquisition by a larger and more diversified firm. Grocery-anchored shopping center REIT Kimco ( KIM ) is acquiring RPT Realty ( RPT ). This will result in RPT Realty 7.25% Series D Cumulative Convertible Perpetual Preferred Shares ( RPT.PR.D ) being absorbed by the surviving company.

KIM has two BBB- rated public preferreds that offer considerably lower yields. Placing RPT-D beside them, we see an opportunity to lock in a healthy 7.1% yield which becomes safer from the acquisition.

Notable Risks/Issues With Preferred Securities

• Capital upside (if any) is not guaranteed: Although we discuss many preferreds and say they yield x% and offer up to y% capital upside, the capital upside is not guaranteed to happen. It isn't predictable or repeatable since it relies on interest rates to drop and gives Mr. Market the indication that the issuer can find cheaper financing and possibly redeem these. Depending on the original terms and the purpose, that may never happen. As such, preferreds must be purely purchased for their income level at your purchase price.

• Will not participate in the growth of the company: If you really like a business for its tremendous growth or value-unlock potential, then the preferreds aren't the place to invest (unless you buy convertible preferreds, which is out of the scope of this article). But if you seek a steady income, protected by the prosperity of a company, then preferreds will suit your needs better.

• Low Liquidity: Preferred securities often trade thinly, and depending on the volume you are looking to purchase, it may be difficult to build or exit a sizable position at a good price.

Conclusion

Rising interest rates have created a rare opportunity in an under-the-radar corner of the fixed-income market. Preferred securities, a $1 trillion asset class, are offering some of their juiciest yields in years, and these bargains must be utilized to further our financial goals.

If you are not very sure about individual names, then a dedicated allocation to actively-managed preferreds through finds like:

• Virtus InfraCap U.S. Preferred Stock ETF ( PFFA )
• Nuveen Preferred & Income Opportunities Fund ( JPC )
• Cohen & Steers REIT & Preferred Income Fund ( RNP )
• Flaherty & Crumrine Dynamic Preferred and Income Fund ( DFP )

...could provide similar benefits of discounted prices and large dividends, coupled with the power of diversification. I personally own all four of the funds in my retirement portfolio.

Our Preferred portfolio has +45 preferred securities from a wide range of industries, targeting a +9% overall yield. In today's markets, we see several preferreds trading at pennies on the dollar, and despite moderate headwinds from higher rates (consistent with almost every public company today), the issuers are highly capable of continuing preferred dividend payments despite what the Fed chooses to do for the next 3-6 months.

For further details see: