Five Irrefutable Reasons to Invest in Preferred Stocks

Over many years and many interactions with investors, I've noticed that there is a natural gravitational pull when the subject turns to income. That is, the conversation seems to always gravitate toward dividend-paying common stocks (or REITs or MLPs) or bonds (or bond funds).   

It's understandable, really. Most stocks and most bond funds are liquid, unlike another popular income-generating investment – physical real estate, which can be timely and costly to buy and sell.  

What's more, you can find many worthwhile investments trading on the major exchanges that pay 5% or more annually. In fact, there are quite a few investments that yield 5% or more in my High Yield Wealth portfolio. 

Most of these investments are equity oriented. Thanks to the board members at the Federal Reserve, most U.S. Treasury securities yield no more than a percentage point or two; many quality municipal and corporate bonds yield little more than that. Investors looking for yield in bonds must look overseas or to emerging markets or to sovereign debt bond funds. 

Recently, though, preferred stocks, which many investors don't even consider, were added to the High Yield Wealth portfolio.

I can understand individual investors overlooking preferred stocks because the market is relatively small. The total market value of preferred stocks in the United States is a mere $155 billion – 1% of the value of the common stock market. I'm sure lack of media coverage also contributes to investor indifference.  

That said, preferred stocks are worth knowing. Below you'll find five reasons why every income investor should consider adding preferred stocks to their portfolio: 

1. High Yield – Most preferred stocks yield above 6%, and some yield as high as 9%. What's more, the payout can't be altered by management. The payout on preferred stock is contractual and is stated as a percentage of par value (usually $25). 
2. Safety – Preferred stocks have a higher claim on earnings and company assets than common stock. Preferred dividends must be paid before common stock dividends. Most preferred stocks are rated by Moody's and Standard & Poor's. That means many investors can use preferred stocks as a fixed-income addition to their investment portfolio.
3. Low Volatility – Because of bond-like qualities, preferred stocks tend to be less volatile than common stocks or other equity investments. The higher-quality issues also tend to have correlation characteristics similar to bonds; therefore, they can lower overall portfolio volatility while increasing portfolio yield. 
4. Tax Efficiency – Preferred stocks can be more tax efficient than bonds and many pass through equity investments. Interest is taxed at your marginal income tax rate, as are dividends and distributions not considered a return of capital on master limited partnerships and real estate investment trusts. Qualified dividends are taxed at a maximum rate of 15%. Many preferred stocks pay qualified dividends. 
5. Liquidity – Preferred stocks trade on the major exchanges just like common stocks, real estate investment trusts, and bond funds. 

In this ultra-low interest rate environment, there is another reason to like preferred stocks – carry trade; that is, the ability to borrow at a very low short-term rate and invest at a much higher rate, such as the rate offered by many preferred stocks. A proper carry-trade strategy can safely boost yield by 25% or more. 

The following example highlights the added income and yield leverage (in this case, borrowing 30% at a low rate) can provide.  

There are a couple of considerations investors must keep in mind, however. Leveraging a single investment is risky, which is why I don't recommend doing it.  Borrowing cost is another. Individual investors can't borrow as cheaply as institutional investors. In this market, many institutions can borrow at less than 1.5% annually; most individual investors will have much higher borrowing costs. 

To gain the advantages of preferred stocks, as well as low leverage costs and diversification, I recommend investing in a leveraged preferred closed-end fund (CEF), which trades just like individual preferred stocks on the major exchanges. I recently added a leveraged preferred CEF to the High Yield Wealth portfolio.  This investment yields more than 7.6%, is well diversified across issues (many are available only to institutional investors) and geography, and pays income monthly instead of quarterly. What's more, I expect this CEF to lower overall portfolio volatility. 

Preferred stocks are a welcome addition to any income investor's portfolio, which is why I expect to see more of them show up in the High Yield Wealth portfolio over the next 12 months.