Preferred stocks can be a great way for investors to secure fixed-rate divdends while benefitting from a company’s growth. Below, Richard Moroney, editor of Dow Theory Forecasts, explains why preferreds can be the income investor’s best friend.
“When we profiled preferred stocks March 9, 2009, we wrote that ‘the broad sell-off has presented opportunities for aggressive investors looking to bet on a rebound in financials.’ As it turned out, the S&P U.S. Preferred Index, a capitalization-weighted index of 85 securities, bottomed on March 6 and returned nearly 169% for the remainder of 2009. For the year, the index returned 45.0%, versus a 26.5% gain for the S&P 500 Index. Over longer periods, preferred stocks have generated much more modest returns. The Merrill Lynch Fixed Rate Preferred Index, which tracks traditional fixed-rate preferreds, has an annualized total return of 3.2% for the 10 years ended 2009. Last year the index returned 20.1%. The Merrill Lynch Capital Securities Index, which holds fixed-rate and hybrid preferreds and is similar to the S&P U.S. Preferred Index, has a 10-year annualized return of 6.0% and jumped 45.8% in 2009.
“Income investors can appreciate the lofty yields of preferreds. The S&P U.S. Preferred Index yields about 7.4%, well above the 2.0% yield of the S&P 500 and 3.7% yield of the 10-year Treasury bond. The Merrill Lynch Fixed Rate Preferred Index yields about 7.2%, putting the spread relative to the 10-year Treasury at 3.5%, roughly in line with the average of 3.7% since 1997. ...
“ETFs investing in preferreds are built around passive indexes and have annual expenseratios of only 0.45% to 0.60%. iShares S&P U.S. Preferred Stock Index Fund (PFF 36.95 NYSE – yield 7.90%) mirrors the S&P index and is the largest preferred ETF based on assets. PowerShares Preferred Portfolio (PGX 13.59 NYSE – yield 7.10%) tracks the Merrill Lynch Fixed Rate Preferred Index.”
Richard J. Moroney, Dow Theory Forecasts
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Gentlemen Prefer Preferreds
Carla Pasternak, editor of StreetAuthority’s High-Yield Investing, also reviewed the basics of preferred investing in a recent letter. Below, Pasternak’s analysis of a particularly juicy preferred stock.
“Phil, a friend of mine, recently came to me with an investment dilemma. ‘I’m close to retirement,’ he said, ‘and I’m searching for income investments. But how do you find yield in today’s environment? The banks pay next to nothing, and government treasuries are not much better.’ Phil went on to say that a buddy of his recommended a company that would be suitable for his retirement. ‘It’s called Realty O,’ Phil said. ‘Its symbol is O. It’s a REIT and it leases properties to regional and national chain stores. He also said it pays monthly dividends.’ Phil said he did some of his own research. He discovered that Realty O issued Class E preferred shares and that the company also has bonds. ‘All three seem solid, Carla, but I’d really like your opinion on which is the best income investment,’ Phil said. Phil went on to say that he has some idea on how to evaluate the bonds, but that the preferreds aren’t that easy: ‘They’re 6.75% Class E Cumulative Redeemable Preferred Stock. I found out they can be called at the issuer’s option after December 7, 2011. Carla, what does all that mean?’
“I explained to Phil that I couldn’t give him specific individual investment advice, but if the question was of sufficient interest to my readers, I could write about it. As I started my research, I saw that he was on to something. The Realty Income Corp. Series E Preferred shares (O-PE 25.48 NYSE – yield 6.70%) are intriguing. They’re among a handful of preferred shares that pay monthly dividends and that are also cumulative. Monthly dividends. Cumulative. Trading below the call price at $24.13. A coupon rate of 6.75% and a current yield of about 7%. Yes, Phil’s friend had steered him correctly. This stock was one of the safest ways to get a stable monthly income stream, with some capital gains potential to boot. The pick was definitely worth sharing with my subscribers. Here’s why:
Preferred vs. Common: And the Winner is...
“Preferred dividends offer the safety most income investors want. Before dividends can be distributed to common share holders, preferred stock holders must be paid. ... Preferred dividends are safer, and often their yields are higher as well. Realty Income’s common carries a very respectable trailing yield of [about] 6.5%. As good as that is, it’s still less than the preferreds. The trade-off is that the common generally provide more upside than preferreds. So, if capital gain is what you’re after, the common may be your ticket. But for safety and income, preferreds will do the job.
Cumulative Dividends Are Safest
“When we saw that Realty Income’s preferred E shares were cumulative, we took a second look. Most preferreds are non-cumulative, which means if the company runs into trouble and is forced to suspend dividends, you won’t get them at a later date when the company recovers. With the cumulative preferreds you will. The dividends accumulate from year to year and no common dividends can be paid until any missed dividends are paid to the preferred holders. ... This feature makes the cumulative preferreds almost as secure as bond income. [And] since preferreds trade like stock on a major exchange, they are far easier to buy and sell than bonds, which are less actively traded. ... So, to return to Phil’s original question, should you buy the Preferred E? ... If you’re seeking secure monthly income with an above- average yield, it doesn’t get any better than O-PE. Given that the shares are still trading below their redemption value, now is a good entry point.”
Carla Pasternak, High-Yield Investing
