Retirees Need Bigger Yields; This Is One Way To Do It

by: ColoradoWealthManagementFund

Summary

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

The duration risk may seem fairly scary, but the yield on cost should be quite steady so long as the securities won't default or be called.

It is important to design the portfolio to build income over time so using nothing but preferred shares and spending all of the coupon payments won't work.

The equity indexes are pretty high, a warning I've been shouting for over a month, and investors should be very careful.

Many retirees are seeking a safe path to increasing income in retirement. Of course, "safe" is always a relative concept. No one should confuse buying preferred shares with buying treasuries. There is a material amount of risk because it is possible for the company to default, go bankrupt, and leave preferred shareholders pretty much wiped out. If you're willing to take the risk in search of yields, then this is the right article for you.

Last time I wrote about using preferred shares in retirement, the focus was on having a conceptual understanding of how to "safely" use them in the portfolio. If you haven't seen that, you'll want to open it in another tab and check it out when you're done here.

If you're interested in investing in preferred shares of mortgage REITs, I would suggest the work I did comparing the preferred shares with recent prices and yields incorporated for all the securities.

The Ideal Situation

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. Of course, investors will still get hit with years where the market crashes and there is little they can do beyond have the courage to withstand the hit and ensure that they have enough cash on hand to make up for any shortfalls from cuts in dividends or defaults on securities.

The importance of building income over time is amplified by the impact of inflation over time. Retirees are keenly aware how easily costs can be shifted onto their demographic through the combination of low interest rates and cost of living adjustments. Because retirees must be prepared for increasing costs in retirement, it would be very dangerous for them to focus solely on the income their portfolio will generate in the current year rather than projecting both income levels and the growth rate of income.

It would be dangerous to emphasize social security too much in the retirement plan. It is one significant part of the cash flow planning process for most retirees, but the adjustments for inflation don't always keep up with the costs that the retiree is experiencing. There is also the issue with the current payout to income ratio being unsustainable. The result was what I would call a fatal flaw in social security.

Great Yields, But Zero Growth

Investors need to recognize that their preferred shares should offer great yields but no growth. They should also be aware that will be a correlation between risk and return. Generally speaking, investors will only accept risk in exchange for an expectation of creating gains. People who accept risk with a negative expected value are gamblers, not investors. If your retirement portfolio consists of a couple hundred thousand lottery tickets, you might want to seek financial guidance.

Beware Call Options

When investors are buying preferred shares, they need to be aware that the company is unlikely utilize a call option when it is favorable to the investor. If interest rates on preferred shares fall far enough, the callable shares may be called and replaced with new shares that offer a weaker yield. That sucks, but is a very realistic risk for preferred shareholders in our prolonged period of low rates.

As the yield curve flattens further and the 10-year treasury rates are near their lowest levels in several years, it seems prudent to be cautious about the risk of securities being called. When the call option is available and it is materially accretive to common shareholders, it is the fiduciary duty of management to pull the trigger. Calling preferred shares can become accretive to common shareholders when management believes they can call the shares and issue new preferred shares at a significantly lower coupon rate. In my experience, about .625% would qualify as "significantly lower coupon rate" and 1% would very easily qualify.

Beware Default

The next major issue for shareholders that will eventually drive the yield on cost lower for shareholders is the presence of defaults. If a shareholder is only buying preferred shares in a couple of companies, there is a strong chance that none of those securities default within their lifetime. On the other hand, if the investor is only holding preferred shares in a few companies, then a single default could be disastrous.

Concerns About Common Equity Indexes

My economic outlook lately has been that share prices were starting to climb too high. A couple months ago my outlook dimmed and I started reducing exposure to equity index funds. I'm concerned that there are now two pictures of the macroeconomic environment. To see the alternative view in a somewhat satirical piece, check out: "We're Rich! We're Rich! Are Inflated Asset Prices Like Real Wealth?"

Disclosure: I am/we are long PREF SHARES OF DX, GOOD, AND EPR.

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: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.