2023-04-30 14:00:00 ET
Summary
- For retired investors, preferred shares provide income with a higher level of safety.
- Closed-end Funds (or "CEFs") offer several additional features that enhance their safety while allowing for generous yields.
- Safer recurrent income is a key for a retirement portfolio.
- We highlight two CEF-issued preferreds – for a lifetime supply of income, with yields up to 7%.
Co-authored with PendragonY.
Preferred Stocks Provide More Income with Greater Safety
Preferred issues combine some of the aspects of bonds with aspects from common stock. The investor gets an ownership stake, with its potential for appreciation, combined with a dividend payment that is guaranteed (making it similar to the interest payment on a bond).
Since the price of the preferred stock depends in part on the value of the company, it can increase or decrease in value. While the call price (and maturity price if the issue has a maturity date) also impacts the price of the preferred shares, the perceived value of the issuer will always have an impact on the price of the preferred issue.
Preferred shares make great income investments. The main reason is that because preferred stock dividends are guaranteed in the vast majority of circumstances, the income an investor will collect is steady and very predictable. The investor will almost always get more income from the preferred shares of an issuer than from the issuer's bonds. And since the price of the preferreds will often move more than the price of the same issuer's bonds, an investor has a chance to get even better deals by using those price swings to their advantage.
Preferred shares offer retired investors a good mix of higher yields and safety. Exactly what they need when their portfolio income will be needed to cover their living expenses. HDO’s income method recognizes that a high yield doesn’t mean much if the dividend gets cut before the investor can collect. That is why we use preferred shares, to get a safe but generous income stream.
The Preferred Issues from CEFs Offer Even More Safety
Closed-End Funds, or CEFs, offer investors a simple way to get instant diversification. While these funds typically have fewer holdings than exchange-traded funds, or ETFs, they still often have dozens to a few hundred positions. Given the larger research budget of the management and the increased diversity, CEFs offer a great way to purchase a diversified portfolio. This can help increase the safety of an investor's holdings.
Importantly CEFs are strictly limited by law in how much leverage they can use. For preferred shares, the fund must have $2 in total assets for every $1 of preferred shares issued. Holders of a fund's preferred shares are not just protected by management's prudence, there are statutory limits on how much debt the fund can issue. So inherently, CEFs are less leveraged and safer as investments. As a result, no CEF preferred stocks have ever defaulted.
The dividends paid by a fund, just like those of a C-Corp, cannot be suspended as long as the fund is paying the dividends on the common shares. However, unlike a C-Corp, a CEF is required to distribute 90% of the dividend, interest, and realized capital gains it collects from its holdings. This provides yet another level of protection to the preferred shareholders. While the preferred shareholders of a C-Corp can have their dividends suspended whenever management is willing to eliminate the dividends paid on its common shares, a CEF can't stop paying the distributions on its common shares unless it isn't collecting income above its costs.
This requirement to make distributions to the common shares makes it easy for us to determine how safe the distributions on the preferred shares are. We just look at "Net Investment Income," or NII; if it is positive then the preferred distribution is most likely safe. If it fully covers the common distribution, then the preferred distribution is even safer.
Preferred issues from CEFs offer the retired investor additional safety features. This is just what they need when the income their portfolio generates will be needed to help pay their living expenses.
Pick #1: GDV-K Preferred Stock – Yield 5.2%
Gabelli Dividend & Income Trust, 4.25% Series K Cumulative Redeemable Perpetual Preferred Shares ( GDV.PK )
CEFdata.com
GDV invests in stocks with high dividends or high capital gains potential in the financial services, consumer staples, healthcare, and information technology sectors. With interest rates likely to see at least one more increase from the Fed and the big drop in share price for banks given the issues with Silicone Valley and other banks, the financial sectors should produce generous dividends and good capital gains. Healthcare and biotech should also do well. Consumer staples are a defensive sector, particularly if the economy slows. Information tech has done well generally even if it has seen a bit of a pullback more recently. The holding for the fund looks solid and is more than likely to continue producing enough cash to cover the preferred dividends.
GDV-K has an “A3” credit rating from Moody’s. As discussed above because GDV is a closed-end fund, it has leverage limits that increase the issue's safety. No CEF preferreds have ever defaulted. The leverage limit is 50%, but according to CEFdata , GDV has leverage of only 14% which is extremely low. These factors combine for a very safe but still generous yield. The total liquidation value of the K series issue is $150 million out of $2.2 billion in market value for the common shares. In 2022, according to the annual report , NII per common share was $0.20, while payments to the preferred shares (there are several other issues besides the K series) totaled $0.11.
Looking at the source of dividends for the last 12 months, we can see that there is NII to cover a portion of the common distributions and that the fund was required to pay out a "special distribution" because the regular distributions didn't meet the minimum statutory requirements to distribute 90% of its income. They had to distribute more. That indicates that the fund earned more than enough to cover the distributions for the preferred shares.
Given the requirement to distribute NII and realized gains, GDV isn't in a position to suspend the preferred dividends. The managers, Gabelli, maintained the distribution of two funds they managed, GAB and GGT, when the fund didn't support the common share distribution for a short period. It is, therefore, unlikely that the fund will cut the distribution on the common shares and even more unlikely that it will stop the distributions. That makes the distribution of the preferred shares very safe. At ~18% below par, GDV-K is a great buy for income investors.
Pick #2: PRIF-L Preferred Stock – Yield 7.1%
Priority Income Fund Inc - 6.375% Series L Cumulative Redeemable Term-Preferred Stock ( PRIF.PL )
There are several CEFs that invest in collateralized loan obligations, or CLOs, that also have issued term-preferred stocks. The five CLO CEFs are Eagle Point Credit ( ECC ), Oxford Lane Capital ( OXLC ), OFS Credit ( OCCI ), XAI Octagon ( XFLT ), and Priority Income Fund (non-traded). For those investors not familiar with different types of preferred stocks, "term-preferred stocks" are preferred stocks that have a maturity date unlike the vast majority of preferred stocks that are perpetual (having no mandatory redemption date). Therefore, "term-preferred stocks" are very similar to bonds because the issuer is obliged to pay the principal at the maturity date, though they are still lower in the capital stack.
PRIF-L is a "term-preferred stock" with a maturity date of 3/31/2029. It can be called at $25 on/after 2/28/2025, but given that it is trading well below par, a call would be a good thing and certainly nothing to be concerned about.
Priority Income Fund's common stock is not publicly traded but files with the SEC and its preferred stocks trade on the NYSE. We have complete access to their financial information . It is simply less well-known. PRIF-L (PRIF.PL) offers yields very similar to that offered by Eagle Point Credit's issue ( ECCC ) while providing additional diversification across more CLOs and CLO managers.
Looking at the financial data , PRIF has its distribution covered by 151% based on NII. That ratio is calculated after the distributions for the preferred shares are paid, so there is plenty of cushion which makes this preferred stock one of the most solid.
Looking at the industries where PRIF holds debt, many are in sectors with plenty of potential. The banking and finance sector is less than 9% of the fund's assets are in that sector, and would not be a big enough problem to impact the distributions on the preferred shares if the situation with banks gets worse. And that is an unlikely scenario because the situation with banks has stabilized, with some banks reporting stellar earnings. Much the same can be said for the hotel sector if we go into a recession.
At ~10% below par, PRIF-L is a good buy and a great way to get more diversification in the CLO sector with a relatively safe distribution.
Conclusion
Preferred shares are a great way to collect reliable income for risk-averse investors. Many are nearly as safe as bonds but have a higher yield. It is key to know which preferred stocks you are investing in, and which have the highest margin of safety. At High Dividend Opportunities, we value preferred stocks because it provides us with lower price volatility and a safer income, especially if we hit a mild recession later this year. This is why we cover 50 preferred stocks as part of our Preferred Stock Portfolio which currently yields 8.7%.
As discussed above, the preferred shares of CEFs carry even more safety features, and we value them. GDV-K and PRIF-L offer reliable income streams at yields of 5% and 7% respectively. This is just right for income investors that want higher yields without giving up on safety. Retired investors can benefit from holding these preferred shares with their mix of higher yields and reliable income to help them cover their living expenses in retirement and for a lifetime supply of income. It is great to be an income investor!
For further details see:
Retirement: 2 Great Preferred Stocks For Safer Income