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The Preferred Road to Income

It’s hard out there for income investors. Thanks to the Federal Reserve, interest rates remain near historic lows.

Money markets and risk-free Treasuries haven’t offered attractive yields in nearly a decade. Even before the market’s return to volatility, the Fed’s own longer-run forecast for its benchmark federal funds rate was just 3.5%. Yes, you read that right.

If the Fed’s forecast proves correct, it will be the most pathetic normalization of interest rates in the central bank’s history.

Income investors already long for the few months in 2007 when the short-term rate peaked at 5.25%, and money markets yielded accordingly. That level now appears likely to remain a distant memory.

Although the U.S. is nominally in a rising-rate environment, disturbing economic data along with turmoil in the global markets have dampened expectations of further rate hikes this year.

At the time of the Fed’s December rate increase, its first in nearly a decade, most observers expected the central bank to raise rates another four times this year. But right now, a slight majority of traders are betting that there might be just one more quarter-point hike this year.

Consequently, income investors have to prepare for rates to remain lower for even longer than previously expected.

Some call this period the “New Mediocre,” other refer to it as the “Lost Decade.” But whatever you call it, the need for income doesn’t just go away.

The safest dividend stocks, regulated electric, water and gas utilities, generally yield between 3% and 5%.

Although we have some high yielders in our portfolios, most income investors shouldn’t stretch for yield. After all, high yields don’t come without higher risk.

Therefore, most income investors are best served by allocating the vast majority of their assets to safer stocks that yield between 3% and 5%, and then, depending on their risk tolerance, carefully selecting from among the higher yielders for the balance.

It’s Good to Be Preferred

But there is another way.

In the fixed-income sleeve of our Income Portfolio, we hold three preferred stocks. These are considered hybrid securities because they have characteristics similar to both debt and equity. In fact, one of our preferred holdings is even convertible into shares of its issuer’s stock, though it’s deep out of the money so it typically acts more akin to a bond.

Like bonds, preferred stock dividends offer a fixed payout. But instead of being taxed as ordinary income, preferred dividends are typically taxed at the long-term capital gains rate, just like dividends from stocks.

And like bonds, if you buy into a preferred at or below par value or its call price, then you’ll be made whole on your investment when it’s eventually redeemed.

Preferreds often sport higher yields than a company’s common stock and bonds. And the issuer also has a greater obligation to pay preferred shareholders before common stockholders—hence, their “preferred” status.

Similarly, preferreds also come out ahead of the common in a company’s capital structure. In the event of bankruptcy, preferred shareholders are next in line to get paid after bondholders, while common stock shareholders are last.

Because of their position in the capital structure, preferreds usually have a lower credit rating than an issuer’s bonds. That’s one of the main reasons why preferreds offer higher yields than other securities–the higher yields are meant to entice investors to assume greater credit risk.

Despite preferreds’ relative riskiness compared to bonds, their fixed-income status helps them do a decent job of holding their value. Although preferred shareholders don’t participate in a stock’s upside like common shareholders do, they tend to avoid the sharp drops that common stockholders must endure during bear markets. And during normal times, preferreds tend to trade within a narrow band around their par value.

The Issuer’s Perspective

So now that we know why income investors should explore preferreds, it’s important to consider why companies choose to issue these securities, so that we can better appreciate their risk.

Preferred issuance often coincides with periods of uncertainty at an economic, industry, or company level. Although the dividend on a preferred is more expensive for a company than paying interest on bonds–the payout is funded by after-tax profits–preferreds generally offer greater flexibility than debt during hard times.

Despite paying fixed income, preferreds are counted toward equity on a company’s balance sheet, a crucial distinction from bonds. So if a company’s credit metrics are already stretched, and they want to tap financing that won’t stretch it even further, then preferreds can be an attractive option.

And while the company is obligated to pay a preferred dividend before the common stock dividend, it can choose to suspend payment if cash flows come under pressure. Unlike missing an interest payment, a suspended preferred dividend doesn’t count as a default.

To guard against such a possibility, some investors narrow their focus to cumulative preferreds, which require a company to make up any lost payments once the dividend is reinstated.

The State of the Preferred Market

Lastly, it’s worth contemplating the state of the preferred market. Here, too, we’re feeling the pinch from the Fed’s years of pursuing a zero interest rate policy.

That’s because with interest rates at historic lows, utilities haven’t needed the flexibility afforded by preferreds nearly as much as in the past. Debt is much cheaper by comparison.

Indeed, the golden age of utility preferred issuance ended more than a decade ago. During the 15-year period through the end of 2004, utilities issued an average of $4.4 billion of preferreds annually (back when all those billions actually meant something), while the number of issuances averaged 36 per year.

By contrast, the utility sector saw just four preferreds issued last year, for a total of $2.3 billion.

So when it comes to utility preferreds, a lot of money is chasing relatively few issues. The good news is that this limited inventory should help support values if it turns out rates end up rising more than we anticipate.

And ultimately, higher rates will help revive the utility preferred market by making the security an attractive alternative to issuing debt again.

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