This Little-Known Asset Class Is Perfect For Income In An Uncertain Market
Another day, another dour economic report.
This latest one comes from the retail sector, registering a tepid 0.4% monthly sales increase, half the growth rate economists anticipated. Having depleted their savings and run up hefty credit card balances, tapped-out consumers are growing increasingly weary.
Meanwhile, housing starts softened again last month, and a 9% decline in permits doesn’t bode well for near-term construction. While mortgage rates have pulled back from their peaks, high borrowing costs have depressed demand, shrinking residential investment for seven straight quarters. That’s the longest downtrend since the 2008/2009 recession.
Elsewhere, the manufacturing sector is showing a few cracks. Business investment has cooled. And with tighter lending fueling talk of a potential credit crunch, forecasters are upping the odds of the U.S. officially sliding into recession.
Corporate earnings are already there. Look no further than Home Depot, which just released a dud of an earnings report and warned that 2023 was shaping up to be “a year of moderation.” It’s not alone. S&P 500 profits have now contracted in back-to-back quarters. And FactSet Research is estimating a 6.3% drop next quarter, suggesting this slowdown could get worse before it gets better.
If investors didn’t have enough worries, the looming congressional debate to raise the debt ceiling (now at $31.4 trillion) could bring another round of chaos. It’s enough to make anyone skittish.
Even Warren Buffett seems to have grown a bit cautious of late. While famously bullish on the American economy, Berkshire Hathaway dumped $10 billion in net stock positions last quarter after unloading $15 billion the prior quarter. That’s $25 billion in net sales over the last six months… not exactly a vote of confidence.
Okay, enough of the doom and gloom. My intent isn’t to frighten you but merely to point out that the market is facing a few macro headwinds right now. It happens. Fortunately, I’ve got the perfect solution.
Not A Stock, Not A Bond…
Despite its low correlation with traditional stocks and bonds and ability to dampen volatility, this hybrid asset class is conspicuously missing from many portfolios. It offers shelter amid the gathering storm clouds while still dishing out some of the richest yields in the investment-grade universe.
And to top it off, those distributions receive favorable tax treatment and are typically classified as qualified dividend income (QDI) — providing an even wider after-tax yield advantage.
What’s the catch? There’s not one, although there are some important considerations. For starters, preferred stocks behave more like bonds. That’s not necessarily a bad thing (particularly in market downturns). It simply means they are more sensitive to interest rates and perceived credit quality, whereas common stockholders are more attuned to sales and profits.
We all understand that common stocks generally reflect the underlying business’s successes (or struggles). If it performs well, then investors will be rewarded commensurately – and dividends will likely be raised. If it performs poorly, then the opposite is true.
By contrast, preferred stockholders don’t directly participate in the profitability or growth of the business. They just clip coupons. And like most fixed-income instruments, these securities aren’t as responsive to day-to-day events. They don’t fluctuate wildly with every earnings report or gyrate with each new industry data point.
Translation: they are less volatile.
Here’s how I sum it up.
Common stock allows investors to fully share in a company’s success, but they must also feel the sting of any failure. The preferred route means less appreciation potential if the business prospers, but also less vulnerability to downturns.
These securities are built for income, not growth.
It’s not unusual for a preferred stock to trade in a narrow band and go years without straying more than a few dollars from its par value. But that doesn’t mean they are immune to selloffs. Preferreds can be driven downward by rising interest rates. They can also be pressured by a weakening balance sheet or credit downgrade – anything that might threaten future dividends.
But in general, preferred shares are less jumpy than common shares. Plus, when harsh conditions necessitate a cut in common stock dividends, the preferred distributions usually continue without any interruption.
Different Flavors To Know…
You’ll notice I said “usually.”
While rare, preferred dividends can sometimes be postponed in times of extreme financial distress. But even then, there is a silver lining. In many cases, the missing quarterly dividends must be paid and caught up at a later date when financial conditions improve. So if two payments were skipped in a bad year, preferred holders might be entitled to six the next.
This type of preferred is referred to as “cumulative.”
With non-cumulative shares, missed payments don’t necessarily accrue. But they may have another protective clause. If preferred share dividends are suspended for some reason, common share dividends must also be restricted until payments are first reinstated on the preferred.
Under this provision, if there isn’t enough cash to pay both groups – the preferred holders go to the front of the line. Incidentally, the same is true with regard to any residual claim on assets in the event the business is liquidated. While preferred stocks are subordinate to bonds in the capital structure, they rank ahead of common stocks.
Finally, I should mention that some preferreds are convertible into common shares at some point in the future. And there’s a whole sub-sector of unique preferreds whose coupon rates start out fixed for a few years and then switch to variable. These can be especially valuable during periods of rising rates.
As you can see, preferred stocks come in many different flavors. This is a $1.2 trillion global market. These high-paying securities are primarily issued and backed by utilities, telecoms, insurers, and other regulated businesses. Because they aren’t treated as debt towards capital requirements, preferreds are a favored tool of banks. Given the well-documented (and overblown) fears in the banking sector, widespread pockets of value are waiting to be exploited.
At least until the window closes.
I’ll have more to say about preferred stocks (and why they make sense right now) in a future piece. But for now, if you haven’t considered this underappreciated asset class yet, perhaps it’s time to start.
In the meantime, I’m not waiting around for Uncle Sam to take care of my retirement needs, and you shouldn’t, either…
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