The Fed's recent statement that they intend on keeping rates low into 2014 may be good for equity markets, but it's bad news for retirees searching for much needed income. With interest rates on a 10-year U.S. Treasury bond yielding just over 2% and the rates for shorter-term corporate's in the same ballpark, where can income investors find enough income to live off of?
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 (he bought them years ago), they were due to mature over the next few weeks. If he reinvested in new CDs, he wouldn't get anywhere near 5.5%. He would barely get 2% for a mid-term CD. What to do?
One solution for investors would be to go the route of dividend paying stocks - especially stocks that have a track record of raising their dividends. While this is a good solution for some, investors that are more risk averse, or who need to protect principal will find dividend paying stocks too aggressive. As part of a broader based allocation, dividend payers certainly play an important role.
Another solution for enhanced income as part of a larger portfolio are preferred stocks. Preferred stocks are like a hybrid between regular common stocks and bonds. Each share of preferred stock is normally paid a fixed, relatively high dividend and in case of bankruptcy, has priority over the common stock in terms of claims against a company's assets. In exchange for the higher income and added safety, preferred shareholders miss out on large potential capital gains [or losses].
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. As per the Fed's low rate declaration, share prices of preferred's should hang in there over the next year or so.
Conversely, if interest rates were to start rising, the price of preferred's could drop like a rock. 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.
Another risk with preferred's is that of them being called. While this can actually be an advantage if they are trading below par, it can actually cause a loss if the stock is trading at a big premium. For example AT&T (T) has a preferred [ATT] that recently was trading in the $26.50-.75 range, and then they announced that they are going to call it in mid-February at $25. Investors who bought in over the last 6 months or so at that high price, are going to end up taking a loss ( even if you include the dividend payments.) With rates so low, many issuers will take advantage of call features and then re-issue new preferred's at more favorable rates, so buyer beware.
There is also a risk that the issuer will not make a dividend payment. Certain preferred's (cumulative) will ensure that you end up getting that dividend payment some time in the future so long as issuer starts paying again. With other preferred's the money is lost.
Floating Rate Preferred
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 preferred's come with variable interest rates, generally linked to the 3 month Libor with additional basis points. For example, MetLife (MET) 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.
For a comprehensive list of Preferred stocks check out www.quantumonline.com.
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.
Additional disclosure: I have no personal position in MET-A or ATT 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.