Investing For Retirement: Are You Using Preferred Shares?

by: ColoradoWealthManagementFund

Summary

Investors buying preferred shares for yield in retirement are taking on both duration and credit risk.

To mitigate credit risk investors should be wary about buying both common stock and preferred shares in the same company and limit total exposure.

There is some substantial duration risk due to preferred shares not having a set maturity, but high yields offset the risk.

Because preferred shares can often have a current yield over 6% and in some cases over 9%, the effective duration risk is reduced.

Investors should be very wary of the call risk and need to factor it into all of their investing decisions on preferred shares.

There are some very favorable characteristics of preferred shares. For the retiree seeking a respectable yield in retirement, preferred shares are certainly one option. In this piece I'm going to focus on how retirees can use preferred shares and how to think about them to improve long term performance.

Thought Process

When investors use preferred shares as part of their retirement strategy, they are taking on some fairly substantial duration risk and very material credit risk. Investors buying preferred shares in established global companies with strong moats and AAA credit ratings are certainly facing lower levels of credit risk, but there is always the potential for a default.

Remember that two of the biggest threats to this kind of security, assuming no major call risk, are the risks of falling profits (see oil or mining companies) or a straight up fraud. Remember Enron and avoid buying preferred shares if you think management is untrustworthy.

No Doubling Dipping

If your portfolio is going to include preferred shares and common shares, the combined allocation to a single company still should not be exceeding 5% most of the time. In some cases I'll go higher but I set my hard limit at 10%.

Steady Yields

The current yield on preferred shares will change on most days as shares will move at least one cent up or down. Investors should be watching the current yield on their securities, but for the most part a retiree investing in preferred shares should be doing it to lock in the current yield.

I almost never use the term "yield on cost" in my articles, but it is a very useful concept for long term investors to think about their investing strategy and the consequences of their decisions. So long as the dividend is not suspended and the position is not exited, the yield on cost remains flat. While investors would always love to see the yield on cost grow, locking in a respectable yield on cost is a substantial advantage in preferred shares. The dividend can be cut, but it indicates a very severe failing of the company rather than a simple decision by management about their allocation of cash.

Building Income

The ideal situation for an investor in retirement is to be able to emphasize a portfolio that regularly sees both the account balance and the income increasing on a quarterly or annual basis. Investors can't get the full level of portfolio yield that they may be looking for today from strictly buying dividend champions. Preferred shares are an option to supplement a traditional dividend growth portfolio, but they shouldn't be seen as a complete replacement.

Remember that many securities are exposed to call risk and all securities are exposed to default risk. An investor that invests $400,000 in preferred shares today and spends 100% of their dividend income in each year is likely to see less dividend income two decades from now than he or she does today.

Occasionally Changing Companies

While retirees would be wise to make their preferred shares strategy part of their long term income strategy for a healthy retirement, there are still times when a reallocation is desirable.

For a moment, let us disregard the influence of credit risk and spreads on trading. These are very real costs, but for a moment I want investors to focus on a different concept.

If the spreads are small enough to be immaterial, there are times when it makes sense to reallocate between preferred shares of different companies to take advantage of superior pricing opportunities. In some cases a single company may have different series of preferred shares where one series will offer investors superior risk adjusted returns due to the combination of "call risk" and current yield.

Market Failures Can Happen

In an efficient market, it would make sense that call risk (given a set level of credit risk) would always demand higher levels of current yield. If the only difference in the risk on two securities is the call risk, then the one that requires the investor to bear that risk should offer some additional yield as compensation.

You can see an example in a recent article I did demonstrating two preferred shares on the same company where one was offering better current yield, a larger discount to par, and longer protection from calls. This was a great scenario for preferred shares.

Why You Should Consider Preferred Shares

Short term rates remain around .25% to .5% despite the Federal Reserve trying to encourage investors to believe the economy is improving. The weak yields are driving up asset prices throughout the economy. For a better understanding, check out this satirical piece: " We're Rich! We're Rich! Are Inflated Asset Prices Like Real Wealth?"

Disclosure: I/we 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.

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