Higher Payouts… Less Risk… What You Need To Know About These Unique Securities

nathanIt’s no secret that dividend yields aren’t what they used to be.

The average payout among S&P 500 stocks has sunk to less than 2%. Even on a decent-sized $500,000 portfolio, that still amounts to just $10,000 in annual payments — or $833 per month. That doesn’t exactly add up to a lavish retirement lifestyle.

Fortunately, there are alternatives. As the Chief Strategist for High-Yield Investing, I’ve spent most of my career scouring obscure corners of the market for hidden yields of 6%, 8%, 10% or even more. For example, I recently profiled corporate bonds here and here — and why they’re poised for a big rebound in 2023.

But one of my favorite hunting grounds to bag these big payouts is within an asset class you may not even know exists.

I’m talking about preferred stocks.

What Are ‘Preferred’ Stocks?

You can think of preferred stocks as a cross between a stock and a bond. They offer equity ownership like ordinary common stock, but also the stability and high income stream of a bond. Preferreds aren’t touted by brokerage firms, and they almost never capture headlines at financial news outlets. So they go overlooked by most investors.

But taking a few minutes to learn the basics can be well worth your time.

Preferred stocks get their name because they receive higher priority than common stock when it comes time to make dividend payments. In fact, many preferred shares contain a protective clause that prohibits the company from paying dividends on the common shares if it’s behind on payments to preferred holders.

This special class is called cumulative preferred stock. They’re entitled to any accrued unpaid dividends. So if the company runs into financial trouble and can’t make payments one year, these investors go straight to the front of the line and will be repaid first before common stockholders get anything.

So where do you find them? Well, preferred stocks trade just like common shares on one of the major stock exchanges. They are a popular fundraising tool for companies that need capital to grow and expand, but don’t want to borrow or issue more common stock. Well-known businesses like Ford Motor (NYSE: F), Wells Fargo (NYSE: WFC) and T-Mobile (Nasdaq: TMUS) have all issued preferred stock.

The average payouts dwarf what you’ll find elsewhere. The iShares US Preferred Stock (NYSE: PFF) ETF offers a robust yield of 4%. That eclipses the 3.5% you’d get on a 10-year US Treasury bond and more than double the payout of the average S&P 500 stock.

And that’s just the index as a whole. Many individual preferreds boast yields of 7%, 8%, and even 12%. And unlike junk bonds, you don’t have to invest in financially shaky companies with questionable credit quality. In fact, many high-yielding preferred stocks are backed by investment-grade rated businesses.

How Preferred Stocks Work

Preferreds are normally issued with a face value (sometimes called liquidation preference) of $25 per share. Dividends are set as a fixed percentage of this value. So a 5% coupon would mean $1.25 in annual dividends ($25 * 0.05), most likely disbursed in four quarterly installments.

For example, a couple years ago I found preferred shares for insurance giant Allstate. The issue came with a 5.625% coupon rate and a $25 par value. That equaled dividends of $1.41 per year, payable in the amount of $0.35 per quarter. Compare that 5.625% coupon rate to the meager 2.1% payout on Allstate’s common shares.

The flip side, though, is that while common share dividends typically rise over time in relation to the underlying profits of the business, preferred dividends usually stay put. Still, they’re much less likely to be cut in a recession or down-cycle.

As a result, preferred shares tend to be less volatile than common shares. They don’t fall as much when company earnings decline, and they don’t rise as much when earnings increase. Generally speaking, most investment-grade preferreds tend to trade on either side of par value in a narrow range between $22 and $26.

That makes them a good choice for conservative income seekers.

A Good Choice For Conservative Income Seekers

Companies usually issue preferreds with long maturity dates of 30 to 40 years. Some are even perpetual and have no stated maturity date. They’re built to provide many years of reliable income. However, that means they also typically behave like a debt instrument. Instead of rising and falling with company earnings, they are more sensitive to changes in interest rates.

Like bonds, preferred share prices move inversely to interest rates. So they typically fall when rates are rising. In fact, we’re already beginning to see this with PFF now in the chart below. That being said, sometimes they get discarded during a wave of panic selling. So when something happens similar to when the Covid-19 pandemic sent markets tumbling, opportunistic investors should be ready to strike.

preferred stocks

The same is true for individual preferreds. First off, prices below par mean a chance to lock in higher yields. Furthermore, assuming you hold to maturity, you will receive the full $25 face value.

That doesn’t mean these securities are bulletproof. Remember, bondholders and other creditors receive top priority for any residual assets in the event of bankruptcy (ahead of both preferred and common shareholders). And the company doesn’t have to go under for investors to lose money. A simple credit downgrade (meaning a higher chance of default on borrowings) is enough to send preferred shares plummeting.

Keep In Mind…

Another thing to consider: Preferreds are callable, meaning the issuer can buy them back from you at the issue price before they mature. Most preferreds can be redeemed five years after they are issued. Companies usually repurchase their preferred shares during periods of declining interest rates in order to refinance (just as you would refinance a mortgage at cheaper rates).

There are also other subsets of preferreds, such as “fixed-to-variable” preferreds that carry fixed coupons for a certain period of time (often until a call date). After that, the payouts become adjustable and reflect the going rate. In any case, the terms of any preferred stock are always spelled out in the prospectus. As always, I suggest reading it thoroughly before investing.

So it’s still important to evaluate the financial health and cash flow prospects of the issuer before investing — that will help you gauge the safety of all future dividend payments.

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