Preferred Shares As A Replacement For Bonds To Increase Returns On One's Nest Egg

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 |  Includes: BXP, DDR, DLR, EQC, FCH, NNN, PSA
by: Henry Nyce

The recent rise in interest rates caused by the Fed threatening to reduce the amount of bonds it buys has cratered the prices of many REIT stocks along with their preferred issues. When the Fed officially ends Quantitative Easing, there is little doubt that interest rates will rise. The average 10-year Treasury bond historically yields about 2.5 percentage points over the inflation rate. Investors expect consumer price inflation to average about 2.5% over the next decade. Based upon that prediction the 10-year Treasury bonds should yield about 5% over this period of time. That's quite a bit more than the present 2.6% interest they now pay.

There is a huge question as to when the Fed will stop bond purchases. The program could begin to slow down next month, next year or several years out. Remember, Uncle Sam is the world's largest borrower and needs to keep interest rates low to finance the national debt. When easing does begin, the Fed will probably do it very slowly. There is also another side of the equation to consider when the Fed stops buying bonds. While stopping Quantitative Easing will likely cause an increase in real interest rates, it will also reduce inflation expectations slightly. This could help mute the effect on long-term bonds and rates will not rise as much as expected. For these reasons, the huge drops in the price of REIT shares and their preferred issues are overdone. There is likely a rebound coming in these share prices when investors come to terms with these realities.

Because of the very low rates that bonds offer, I have turned to preferred shares to give me a reasonable rate of return on my investments. Many REITs have preferred shares that offer good rates of return. The preferred shares of REITs fit well in a tax protected account. The preferred shares do not create any accounting problems for your IRA or 401K accounts. There is no tax liability on your dividends or distributions. One is only taxed when one withdraws funds from these accounts and there are no taxes at all when withdrawals are made from Roth accounts.

These preferred shares offer a steady stream of cash coming into one's account each quarter. Preferred REIT shares offer the investor a level of protection because the trusts own real estate. Since preferred shares rank before common shares, if a REIT runs into a problem, the owners of the preferred shares are more likely than common shareholders to get some of their investment dollars back.

Below are some charts of preferred stocks that have the following qualities:

  1. Preferred shares of REITs that have real estate or real property to support the value of the shares in the event of problems.
  2. Preferred shares which are cumulative meaning that if any dividends are missed, they must be paid before dividends can be paid on the common shares.
  3. Preferred shares that are rated by both Moody's and S&P.
  4. Preferred shares that offer over 6% at their current buying price.
  5. Preferred shares that have a liquidation price of $25.00 and are currently selling for less than this liquidation price.

The first chart below shows the dividends that are offered on the basis of the liquidation and/or original offering price of the preferred shares. The coupon rate on some of these shares is less than 6% based upon these liquidation prices. However all of these preferred shares can be purchased below the liquidation price. You can only make money if the company decides to call these shares back in since they are selling below $25.00 per share.

Preferred Stock Symbol

Coupon Rate at Offer Price

Cusip

Company Symbol

Company

Name

PSA-W

5.2%

74460W875

PSA

Public Storage Inc.

NNN-E

5.7%

637417809

NNN

National Retail Properties

BXP-B

5.25%

101121408

BXP

Boston Properties

CWH-D

6.5%

203233408

CWH

CommonWealth REIT

DDR-K

6.25%

23317H805

DDR

DDR Corp.

DLR-G

5.88

253868889

DLR

Digital Realty Trust

FCH-A

7.8%

31430F200

FCH

Felcor Lodging Trust

Click to enlarge

For anyone who follows the REIT articles on this website, there are several names of trusts above that are recommended by authors who write here. National Retail Properties and Digital Realty Trust particularly stand out in this regard.

The following chart below shows the selling price as of 10/7/13 and the actual rate of return based upon the current selling price.

Preferred Stock Symbol

Current Selling Price

Rate at Current Price

Moody Rating

S&P Rating

PSA-W

$19.85

6.5%

A3

BB+

NNN-E

$19.75

7.1%

Baa3

BB+

BXP-B

$20.30

6.4%

Baa3

BBB

CWH-D

$20.90

7.7%

Ba1

BB

DDR-K

$21.00

7.4%

Ba1

B+

DLR-G

$19.60

7.4%

Baa3

BB+

FCH-A

$24.00

8.1%

Caa2

CCC-

Click to enlarge

One can tell from the chart above that all of these preferred are now offering over 6% dividends. Four of them are offering over 7%.

Just a note of caution, one should not put all of one's retirement funds in these preferred stocks because there is no possibility of growth. There is also the possibility that interest rates of the 10-year Treasury bond could exceed 6% at some time in the future. If that happens there is the possibility of losing capital; that is the selling price of these preferred shares declining below their current prices.

At this time with 10-year bonds paying less than 3%, these preferred stocks offer a viable alternative to bonds for steady income. While they entail greater risk than Treasury bonds, assuming the government does not default, they offer much better returns with reasonable assurance you won't lose your capital. This is especially true if you diversify among the preferred stocks listed above and maintain a watchful eye on these companies. Investing this way requires a little more work but offers a much better return on one's nest egg.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long on all of the preferred stocks listed in this article.