Forget Stocks Or Bonds: These ‘Hybrid Investments’ Yield Up To 7%
How high can stocks go? Since breaking through a record closing high on March 5, the Dow Jones industrial average has continued to post fresh highs. The broader S&P 500 index has more recently done the same.
Those were heady times back in October 2007 when both the Dow and S&P 500 closed at all-time highs.
But what happened only two short months later is still fresh in our collective memory. The Great Recession officially began in December 2007.
Nine months after that, in September 2008, Lehman Brothers declared bankruptcy, and lending seized up around the globe.
Investors panicked, stock prices plummeted, and by March 9, 2009, the Dow and S&P 500 had lost more than 50% each.
We’re not likely to see a correction of this magnitude again. This time around, the U.S. economy is improving and companies are awash in cash. Stocks are still reasonably valued, with the S&P 500 carrying a forward P/E (price-to-earning) ratio of 14, based on estimated earnings of $112.50, only slightly above the five-year average of 12.9, according to FactSet.
But the big push behind stock prices is the Federal Reserve’s low interest rate policy, which encourages corporations to fund growth and investors to take risks in search of higher yields. When the proverbial “punch bowl” of Fed cash flowing around the economy eventually gets taken away, stock prices could deflate.
Right now, corporate bond prices are at record levels as investors chase higher yields. And as the money has moved in, bond yields (which move inversely to prices) have been driven down to record lows. Even junk bond yields have dropped below 5%, a far cry from the 22.7% peak in 2008, according to Bank of America Merrill Lynch data.
As interest rates go up, bond prices will go down in order to bring the yield on existing bonds in line with the higher yields on new bonds. If the Fed‘s easy-money policy spurs inflation, the fixed-income payments could also lose value. At the same time, with unemployment rates still above where the Fed would like them, a low-interest environment may stay a while longer — meaning you could continue to enjoy the steady, predictable payments that bonds and preferred shares provide for some time without getting burned.
Put simply, both stock and bond investors face plenty of future uncertainty, but also reasons for optimism.
So which makes a better investment right now — stocks or bonds?
Luckily, you don’t have to make this either/or decision.
Say hello to convertible preferred shares, or “convertibles.” They are the perfect security for an uncertain market. They provide the reliable income of bonds but track the upside of stocks through a conversion feature.
What you need to ask when hunting for the best convertibles are two key questions: What’s the conversion premium or discount? And what’s the payback period?
The conversion premium is the difference between the conversion value of the convertible and its current price. Typically, convertibles sell at a premium because they provide higher payouts than the common stock. But the lower the premium, the better.
The payback period is the time it takes to recoup the conversion premium and break even on your investment in the convertibles compared with simply buying the common stock. Again, the shorter the better.
When I search for convertibles, I look for a short payback period (of less than five years). I also look for a current yield of at least 4.5% and a call date at least two years out so as to provide time to enjoy the superior income and allow the common shares to rise before converting.
As a final measure of quality, I make sure that the underlying common stock had a positive price trend at least over the past six months, to make the conversion feature more attractive.
One that I found particularly interesting is the convertible issue from Beazer (NYSE: BZH), which is a top-10 U.S. builder of single- and multi-family homes.
I did a complete analysis of Beazer Homes 7.50% (NYSE: BZT) convertible issues in the January 2013 issue of my High-Yield Investing newsletter. In the nearly six months since I showcased them, the price has gained a healthy 33%, all while throwing off yields well above 7% for those who purchased them in January.
Even if you didn’t invest back then, at a recent price of $34.45, the Beazer convertibles pay a $1.875 annual distribution, which still gives them a current yield of 5.4%.
By comparison, Beazer’s common stock doesn’t pay a dime in dividends.
Action to Take –> One thing to remember is that the conversion feature on these securities could be worthless if the common shares lose value. Still, unless the company runs into trouble, interest payments and gains on the convertibles should continue to provide solid growth and income.
P.S. — In an uncertain bond and stock market environment, it’s never been more important to find quality high-yield investments. In my latest research, after screening through thousands of stocks, I’ve found 10 high-yield stocks that have been scrutinized for safety and deliver yields up to 14.5%. To learn more about these stocks and gain access to my other high-yield investment opportunities, click here.