For retirees, today’s low interest rates on bonds and deposits puts many fixed income investors, who live off the interest generated by their investments, in a quandary. For example, the interest rate on a 10-year U.S. Treasury bond is well under 4%, and the rates for shorter-term bonds are in the 1-2% range. The question is what to do in this situation.
The following is a prime example of the alternatives faced by many investors: One of my prospective clients was living off social security, as well as from the interest generated by FDIC-insured certificates of deposit (CDs). Although his CDs were paying about 5.5% annually, they were due to mature over the next few weeks. If he reinvested in new CDs, he wouldn’t get anywhere near 5.5%. What to do?
For an investor looking to generate income, one type of investment that might be appropriate as part of a larger portfolio, are preferred stocks. Preferred stocks are somewhere between regular common stocks and bonds. Each share of preferred stock is normally paid a fixed, relatively high dividend and has priority over the common stock of a company's assets in the event of bankruptcy. In exchange for the higher income and added safety, preferred shareholders miss out on large potential capital gains [or losses]. Owners of preferred stock generally do not have voting privileges.
How do they work?
Many preferred stocks begin trading at $25/share, unlike bonds, which usually come in increments of one thousand dollars. For example, Company X issues a preferred stock at $25, with a coupon of 6%, meaning that every year the investor receives 6% on the amount he has invested, and this is usually paid quarterly.
Although this sounds very straightforward, there are also certain risks involved. Preferred stocks are considered to be like long-term bonds in the way they trade. As they can be quite volatile, this means that the same preferred stock that started at $25 can end up trading much higher or lower than its issue price. In today’s low-interest rate environment, many preferred’s are trading well above par as there is a great demand for the high income.
Conversely, if interest rates were to start rising, the price of preferreds could drop like a rock. With interest rates at historic low levels, it seems that at some point in the not too distant future, rates are going to jump, which could mean trouble for many fixed-rate preferreds. Keep in mind that this potential loss is only on paper, and investors who need monthly or quarterly income will still receive their annual 6%. For retirees who may need to dip into their principal, this could pose a problem as there is certainly principal risk at play.
Floating Rate Preferreds
Most investors are aware of fixed rate preferred stock, and for good reason; they make up about 90% of the market. While they may be more popular, investors should take a look at floating-rate preferred stock as a way to profit from higher interest rates.
Floating rate preferreds come with variable interest rates, generally linked to the 3 month Libor with additional basis points. For example, MetLife MET-A (or METprA) has one linked to the 3 month Libor + 100 basis points( or 1%). With the 3 month Libor trading near 0.3% you are looking at a yield of less than 1.5% -- not very interesting. What is interesting is that this particular issue comes with a minimum dividend of $1 per share. Based on a $25 share issues, that is a 4% yield. Not too shabby in today’s interest rate climate. With the issue actually trading under $25, the yield is over 4%. I am not recommending running out to buy this issue, but it’s just one example among many. There are also closed-end funds that invest in these assets as well. For example, Nuveen's Tax-Advantaged Floating Rate Fund (JFP).
Speak to a pro
Such investments can be a little confusing because the terms can vary widely between issues, even when they are issued by the same company. Some of the many different kinds of preferred stocks available are: adjustable rate preferred stock, convertible preferred stock, first preferred stock, participating preferred stock, participating convertible preferred stock, prior preferred stock and second preferred stock. Such variety and the lack of information available to investors means that anyone who is thinking about using preferred stocks should contact a financial adviser. A competent adviser can then explain clearly and in depth whether preferred stocks would be good for your particular situation or investment portfolio.
Disclosure: I have no personal position in MET-A but my clients may own or have owned it. The stocks mentioned are not to be taken as a recommendation to buy. Investors need to research their own investments.