Tax Lien Investments for Income

tax lien investing for incomeA couple of years ago someone I knew from work who was a fairly senior manager with the federal government was able to retire at a much younger age than was typical.  When I inquired as to how he was able to manage this, he said that he had been able to build up his income from part-time tax lien investing to make early retirement a real option for him.

If you are an investor looking for safe income investments, but wanting or needing higher returns than you can get from putting your money into bank CDs, one option to consider is investing in Tax Liens. If done properly, investing in Tax Lien certificates will enable you to realize safe, higher annualized returns than from typical debt investments.

The collection of real estate property taxes is a major priority in every taxing jurisdiction in the United States, as all homeowners know all too well.  If a county or municipality were unable to collect those taxes in a timely fashion, it would be unable to provide the public with important public safety services (police and fire departments) or public schools.  To avoid this problem, all counties in 26 states across the US will place a Tax Lien on any property with delinquent property taxes and then sells the delinquent tax debt to investors.  The county gets their money, the tax delinquent taxpayer gets more time to pay their already past due property taxes, and the investor gets a real estate-secured high yielding investment.

Safer with Higher Returns

A couple reasons that some income investors like to hold government issued Tax Lien certificates as part of their income portfolios are:

1. Rising and falling interest rates do not directly affect Tax Lien certificate rates because the maximum interest rates for Tax Lien certificates are mandated by state law, and actual rates of return are usually determined based on local auction results.

2. Rising and falling stock market prices also do not directly affect the rate of return. Each state has a mandated length of time for the delinquent taxes to be paid.  If they are not made current during this time period, the property is sold to pay the debt.

For most properties that have an outstanding mortgage, the mortgage lender will pay these delinquent taxes before it gets to the foreclosure stage.  The certificates can also be sold or transferred at a discount before the due date allowing the investor to make a smaller profit on the certificate should there be a need for cash prior to certificate redemption.

To illustrate the variability of laws from state to state, the following are examples of maximum interest rates and redemption periods for Tax Lien certificates in three states:

Arizona:  16%, 3 years
Florida:   18%, 2 years
Indiana:  15%, 1 year

The Pros and Cons of Tax Liens

The following video from the real estate investor Phil Pustejovsky is a good summary of the Pro’s and Con’s for investing in Tax Lien certificates.  Phil prefers to pursue opportunities with tax deeds versus tax liens because of the higher return on investment, but I suspect readers of this blog may be more attracted to the hands off aspect of tax lien investing.



As Phil points out, self-education and due diligence are prerequisites for ensuring these become smart investments for income.  If you do think you might want to study up on this type of investment, one good choice would be to try the tax lien investing course by Steven Waters. You can find out more about it by clicking here. ==> Tax Lien Investing




Finally, It’s Time – Convertible Preferred

convertible preferred stockWith the S&P 500 recently hitting new highs and interest rates poised to increase, it sure doesn’t seem like the best of times to be buying dividend stocks if you care about valuations and preserving capital.  So, given the timing of where we are in the economic cycle, is there a decent alternative to just waiting for a pullback before buying those income stocks you’ve been eyeing?

Hidden Opportunities for Income Investors

Viable alternatives are out there, but you have to drill down to find them. Continuing with the “less risk, more yield” theme from my post on baby bonds, let’s take a look at equities.  To minimize interest rate risk, you want to be looking at the stocks of companies whose businesses will benefit from increasing rates.  As mentioned in earlier posts, an example of one sector where this is true is the Financial sector.  To further minimize the risk to dividend payments, we look for companies within those rising rate-friendly sectors that are on a solid growth trajectory.  Unfortunately, these higher-growth companies often have lower dividend yields than their low-growth cash cow brethren.  One thing, however, that many of these higher-growth companies can offer to income investors are preferred shares with attractive yields.

Now the problem with most preferred shares is that they provide a fixed income, and, therefore, trade like bonds, i.e., their prices fall as interest rates increase.  But what if you could get that attractive fixed income while minimizing the effects that interest rate increases would have on prices?  That would certainly be something worth exploring.

An Income Investment Strategy

If you want to put some money to work right now, one possible alternative to consider is to selectively add preferred stocks with a convertible option (so-called “convertible preferreds”) to your portfolio.  I’m not going to summarize the basics of this type of stock in this post (you can click here for a good overview), but the main feature that distinguishes convertibles from non-convertible preferred stocks is that convertibles trade like a bond only while the share price of the common stock of the company is below the specified “conversion price” (unlike regular preferreds that always trade like bonds).  Once the common stock price rises above the conversion price, the price of the convertible preferred rises and falls primarily in sympathy with the price of the common stock, not with changes in interest rates.  Therein lies the opportunity.  What if you could find a convertible preferred issued by a strong growth company in a rising-rate friendly sector with an associated common stock that is trading above the conversion price?  Not only would those dividends be more secure, but the interest rate risk that most preferreds are vulnerable to would largely be mitigated.

An Attractive Income Investment Now

So what looks good right now?  One convertible preferred that my research has uncovered is the KeyCorp Inc. convertible preferred stock Series A (ticker symbol: KEY-PG).  KeyCorp is a growing regional bank holding company that stands to do well as interest rates rise.  KEY-PG pays $7.75 annually per share.  At the current share price of $129.50, KEY-PG has a yield of 5.98%.  Since the conversion price is $14.10 and the common stock (ticker symbol: KEY) is trading at about $14.43, one can expect future price movements of the preferred stock to be more closely correlated with the price movements of the common stock.  Analyst consensus is that the price of KEY will continue to rise as interest rates rise and the general economy improves.

So the play here would be to buy KEY-PG at the current price and monitor the price of the common stock.  Keep collecting the $7.75 per share distribution annually until the price of the common stock reaches $18.33.  When the price of the common stock stays at $18.33 or higher for 20 days, KeyCorp will have the option to force preferred stock shareholders to convert their preferred shares into common shares.  You do not want to do that.  So when the common stock price reaches that level, consider selling KEY-PG for a capital gain and reinvesting that money in other income investments, which by that time should all have relatively higher yields.

If you can discover similar plays with other securities, I think those would be very smart investments for income.


(Disclosure: I recently bought KEY-PG.  Yields and prices mentioned are current as of March 19, 2015.)




High Yield, Lower Risk with Baby Bonds

Baby Bond Investments for IncomeIncome investors are always striving to find the best balance between yield and risk.  The low-interest rate environment of the past few years has forced many income investors to take on more risk than might be prudent moving forward.  There is a type of fixed-income investment that many investors may not be familiar with, but which currently looks attractive from a yield/risk perspective – baby bonds.

Baby bonds?

No, I’m not talking about those European savings bonds intended for parents wanting to start a nest egg for their children.  Nor do I mean the municipal baby bonds (which I may write about at a later time).  What I mean here by baby bonds are those small denomination ($25) debt notes that are issued by business development companies (BDCs) and can be bought and sold on the NYSE or NASDAQ exchanges.

BDCs are companies similar to venture capital and private equity firms that earn income by making loans to small and medium-sized businesses.  Unlike VC and private equity funds, however, BDCs are not closed-end funds, so any interested investor may purchase shares of a BDC company in the open market.  With a pass-through tax structure similar to a REIT or MLP, BDCs are required to payout at least 90 percent of taxable income to its shareholders to avoid having to pay a corporate income tax.  Thus BDCs, typically pay out large dividends (8%-12% yields) to shareholders.  One of the ways that BDCs raise capital for their operations is to sell baby bonds.

Less Risky Than Dividends

If BDCs pay out high dividends, why not just buy shares of the BDC and take advantage of some dividend and capital growth over time?  Well, for one thing, BDC share prices have a notorious history for volatility especially when the economy and markets are under stress.  Dividend payouts have not always been assured.  During the 2007-2009 financial crisis, the shares of BDCs got hammered due to excessive risk taking and the use of leverage.  Dividends were cut.  Today, many analysts believe the companies are in much better shape, but the risk of share price swings and dividend cuts are still very present.

A less risky investment for income investors would be to consider purchasing the baby bonds issued by a BDC.  Since these are senior notes, holders of these bonds must be paid their coupon before shareholders receive dividends.  Market prices for these bonds do not fluctuate nearly as much as stock prices, and BDC baby bonds currently still yield between 5% and 8%.  As some of you may have noticed, purchasing BDC baby bonds is somewhat similar to another one of my favorite investments, i.e, purchasing preferred shares of REITs.  Both types of instruments are callable, but unlike the preferred shares, a baby bond always has a maturity date, which limits interest-rate risk if you do have to sell the bonds early.


As with any debt investment, an investor in baby bonds needs to consider credit risk.  BDCs have done well over the past couple years, but in November Fitch Ratings issued an outlook that is projecting a more challenging period for the industry in 2015.  Fitch notes that some BDCs are resorting to increasing leverage by using off-balance sheet financing.  The bottom line is that increased price volatility of BDC common shares can be expected, and current high-dividend payouts will be in danger of being cut if the economy and interest-rate environment change.  Bond investors, however, do not have to worry about this as long as the fundamentals of the individual company issuing the notes are solid enough to ensure continued payment of the debt.


I believe these baby bonds are smart income investments if investors are willing to do their homework and invest with discipline.  BDC baby bonds should only form a part of a diversified bond portfolio, not the bulk of it.  I believe once purchased, baby bonds should be held to maturity to completely eliminate interest-rate risk.  Since they are callable securities, you should compute both the Yield-to-Call and the Yield-to-Maturity of potential investments to make sure you understand what you are getting.  As interest rates rise over the next few years, it is less likely that these bonds will be called early, but you never know.

One security that I like and that you might consider researching further is the 6.125% Senior Note from Main Street Capital Corp. maturing 4/1/2023.  This note trades under the ticker MSCA, and has a call date of 4/1/2018.  Yield-to-call is 5.99%, and yield-to-maturity is 6.06%.  S&P updated its ratings for BDCs two weeks ago and assigned Main Street Capital an Issuer Credit Rating of BBB/Stable.


(Disclosure: I own MSCA and intend to hold until the bonds are called or mature. Yields mentioned are current as of December 26, 2014.)




Are Annuities Smart Income Investments?

Annuity Income InvestmentsI’ve been meaning to post something on annuities for a while now since some people like to include them in their income portfolio to receive a regular payout.  If you get an “immediate” annuity, the payments can begin quickly; otherwise, you have to wait a certain number of years to start receiving your regular income.  The simplicity of the concept is appealing; however, as they are insurance products, annuities are often shunned by many individual investors because of the high fees and commissions that are typically associated with them.  You are also basically relying on the promises of an insurance company to make your payments.  Investors willing to do a little work on their own can set up their investments to provide equivalent or better returns with, perhaps, less risk.  The following video shows how it can be a fairly simple thing to do (the video is followed by a commercial and some other news items, so stop it after viewing unless you want it to go on – sorry, but I don’t think WSJ will just let me embed a single video):



I think the video does a good job in showing why buying a “deferred” type annuity is a bit silly.  I personally think an immediate annuity can still be a valid option and make a lot of sense for people depending on their circumstances.  Regardless of how enthusiastic we currently are in managing our investments and portfolios, there will surely come a time in our futures when we will no longer have the capability or motivation to do so.  When that time comes, an immediate annuity for income can be a smart investment.  Getting some random quotes on, I’m currently seeing yields of between 5% and 6%, but as interest rates rise in the future, these yields can be expected to rise as well.



Diversification Simplified: Multi-Asset Income Funds

multi-asset income fundsPrevious posts here have looked at different equity investment asset classes that can contribute significantly to your investment income.  The trick, of course, is to select and manage these investments properly so as to maximize their benefits.  Doing this for a collection of dividend-paying stocks, REITs, MLPs, preferred stocks, convertibles, etc. can be quite an ongoing chore.  If you are looking for the income diversity that these various asset types can provide without the headache of actively managing them yourself, it may be time to consider buying shares in a multi-asset income fund.

Wide Range of Income Investments

As the name implies, multi-asset income funds typically contain a wide range of different types of income investments.  They are available as both ETFs and mutual funds and have yields ranging from 3% to 6%.  Since the funds have widely differing investment styles and goals, it is important to understand what type of fund you are buying.  Some funds contain bonds (high-yield, emerging market, convertible) and others do not.  Some avoid certain asset classes like MLPs or preferred stock.  Fund managers are typically given a great deal of latitude to adjust their portfolio allocations based on economic conditions and forecasts.  According to Lipper, about 100 new income-oriented funds using multiple assets have become available since 2010.

Pros and Cons

Some advantages of owning these funds are that they provide higher yields than bonds, but also have the possibility of capital appreciation even as interest rates rise.  A diversified approach also helps avoid overweighting any single type of asset.  With a fund, you do not need to worry about having to periodically rebalance the allocation among asset classes that you normally would if you owned these asset classes separately.

One disadvantage to these funds is that their prices can experience high volatility during short periods of high market stress as they often hold riskier, rate-sensitive investments.  Another disadvantage is that many of the funds that are organized as mutual funds incur high upfront costs.

Smart Investment Moves

If you think you might be interested in these investments, I would suggest that you favor the ETFs over the mutual funds.  I also think these investments are better suited for those who have a long-term timeframe (over five years).  I certainly would not make these funds the primary investment vehicle for my income portfolio, but would treat them as complimentary to traditional bond and equity income investments, providing further diversification.

Here are a couple of ETFs to consider:

Guggenheim Multi-Asset Income ETF (CVY, yield 4.72%, expenses 0.75%)
First Trust Multi-Asset Diversified Income Index Fund (MDIV, yield 5.68%, expenses 0.68%)

If you’re willing to pay an upfront load, consider this mutual fund:

Franklin Income A (FKINX, yield 4.79%, expenses 0.62%)


(Disclosure:  I do not currently own any of the investments mentioned above, but may purchase them in the future.  Yields mentioned are current as of July 11, 2014.  I am not recommending the investments discussed above for purchase, but only that they may be potential candidates for your own research.  Please read the prospectuses for any investments prior to making your own investments.)



Step-up Bonds for Rising Rates

step-up income investmentsThe latest economic data point to an improving U.S. economy with interest rates more likely to rise in the future.  For investors who hold traditional bond investments, this scenario poses increased risk to the value of their income portfolios.  Is there a way to continue getting steady bond income without having to take the hit to the value of the bonds?  As readers of previous posts know, I am not a big fan of bond funds but much prefer direct ownership of bonds held to maturity, partly because it mitigates this interest rate risk.  I believe building a bond ladder (or a ladder of defined maturity funds as mentioned in an earlier post) is still the better way to go.  But if ladders are not an option for an investor, are there any other alternatives that make sense under these conditions?  One type of Investment worth exploring for your portfolio is the step-up bond.

Future Payments are Higher

A step-up bond has a coupon rate that is scheduled to increase (“step-up”) to a higher rate at least once during the life of the bond.  If the coupon payment is increased only once, the bond is called a “one-step” bond, and if the coupon is scheduled to increase more than once, it is called a “multi-step” bond.  Typically issued by Government Sponsored Enterprises (Fannie Mae, Sallie Mae, etc.) and major corporations, these bonds are callable (redeemable) by the issuer at some future date.  Although step-up bonds offer a lower initial coupon rate versus similar fixed-rate bonds, if the bond is never called, the total amount of interest paid over the life of the step-up bond will be greater than the interest paid by a conventional bond that is issued at the same time.  An investor in a step-up bond, therefore, sacrifices current income for potentially higher yield over the life of the bond.

The Positives and Negatives of Step-ups

Besides lessening interest rate risk, the advantages of these bonds are that they are issued by high-quality institutions and they can be traded in a fairly liquid secondary market in case you want to sell them prior to maturity.   The higher future income is ideal for those whose needs for investment income may be more important down the road.  The big downside to a step-up bond, of course, is that the issuer can force you to redeem the bond early by calling it.  This will happen if the coupon rises above market rates, thus forcing you to reinvest at a lower yield.  You might be able to buy a non-callable type of step-up bond (canary call) to avoid this, but these are not as common.  Although the coupon rates on non-callable bonds might be lower than for the callable bonds, you can count on getting the higher yields later.

Considerations for Income Investors

Since interest rates are likely to rise in the future, it is less likely that recently issued step-up bonds will be called. Buying and holding step-up bonds until maturity seems like a reasonable option at this time.  A couple of things to keep in mind as you investigate further:  1) the higher the coupon rate and the closer it is to the maturity date, the more likely it is that a step-up bond will be called, and 2) most step-up bonds pay interest only every six months, so if you want income quarterly or monthly, you might want to consider other alternatives.




Go International: Dividend Income from China

International Investment IncomeFor most American income investors, the equity income portion of their portfolio consists almost entirely of shares of U.S.-based large cap dividend payers.  There are good reasons for this.  The low-risk consistency and reliability that income investors crave are most often found in such investments.  Contrast this with a typical equity growth portfolio.  Most financial advisors would recommend investing a significant percentage of a growth portfolio in international equities.  I’ve seen recommendations for an international equity allocation as high as 30%, and even 40%. 

International Diversification

One reason that dividend investors tend to avoid holding international stocks in their portfolios is that they believe the U.S.-based multinationals in which they are invested already provide adequate exposure for international diversification through the revenue streams those companies derive overseas.  Although it is true that they are getting some international exposure, what one has to keep in mind is that not all international exposure is equally desirable.  In fact, in the current economic environment, some types of international exposure will likely prove detrimental to corporate earnings and may put pressure on dividends.  Specifically, companies deriving income from countries whose currencies are weakening with respect to the U.S. dollar can expect profits to be adversely affected.   

Currency Outlook and Risk

From analyses that I have read, many forecasters are anticipating interest rates in the U.S. to eventually start moving up over the next year.  This is expected to lead to the value of the U.S. dollar rising against the currencies of other countries whose economies continue to struggle, particularly against the Euro, Pound, and Yen.  As commodity prices are expected to remain under pressure, the currencies of countries whose economies are highly dependent on oil and other commodities are also expected to weaken against the U.S. dollar.  These include currencies from such countries as Canada, Norway, and Australia.  

Companies that have significant overseas revenues coming from these countries can be expected to take a hit to their bottom lines starting next year.  Conversely, companies with income from countries whose currencies are expected to increase in value against the U.S. dollar will benefit from the tailwind provided by the currency exchange and will be in a stronger position to maintain and increase dividends. 

So what countries are expected to have currencies that outpace the U.S. dollar?  After reading what various forecasters are saying, I have concluded that the countries to have currencies that will most likely do well against the U.S. dollar are China and Mexico. 

International Dividend Opportunities

China and Mexico have low-cost labor and large manufacturing bases that will continue to make them attractive production centers.  Capital inflows can be expected to boost the GDP of these countries in the coming year and lead to yuan and peso appreciation against the dollar.  To exploit this possible opportunity, I searched for good equity investments from these two countries that would pay decent dividends.   Although I found several excellent potential Mexico-based investments, none of them paid a dividend that I consider to be high enough to qualify them as good income investments.  China, however, presented a different story. 

One income-oriented equity investment that I find particularly attractive is a WisdomTree ETF – the China Dividend Ex-Financials Fund (CHXF).  With a distribution yield of 5.79% and an expense ratio of 0.63%, this fund has exhibited the characteristics of a good equity income investment.  In the 14 months of CHXF’s existence, its price has generally moved in sympathy with larger index-based ETFs, like FXI, but with less volatility.  The fund also avoids holding shares of the shady Chinese banking stocks that I believe are too heavily overweighted in other ETFs.

Another potentially smart investment for income that I ran across is the Taiwanese communications company Chungwa Telecom Company (CHT).  While the telecom business in Taiwan is extremely competitive, CHT’s expanding business on the mainland and elsewhere make its earnings prospects attractive.  The company’s stock currently has a dividend yield of 4.92%. 

Let me leave you with a couple of thoughts to consider:

  • In emerging markets, corruption and weak corporate governance are part of the investing landscape.  Many publicly traded corporations are majority-owned by wealthy families who may or may not have the best interests of other investors in mind.  What these families almost always want to do, however, is extract money from the corporate entities that they own.  In many cases, their preferred way of doing this is through dividend payments.  In China, there is a special case of this wherein the “wealthy family” is in fact the government (in the case of state-run enterprises) and its communist overlords.  They too extract income through dividends.  And when they want more income, they raise the dividends. That is why some investors actually consider some Chinese dividend payers to be good dividend growth picks.  I wouldn’t go that far, but suffice it to say that if the central government has a stake in the well-being of some of your investments (as they do in many of the CHXF holdings), then the dividend payouts from those investments will have a certain degree of protection not available elsewhere.
  • As attractive as these opportunities may look, disciplined allocation is still a must when investing internationally.  I personally would never concentrate more than 10% of my equity income portfolio in any one country outside the U.S., and that includes China.

So don’t shy away from looking at international equity opportunities, just be sure to do your homework.

(Disclosure:  I do not currently own either of the investments mentioned, but may purchase them in the future.  Yields mentioned are current as of 11/15/13.  I am not recommending the investments discussed above for purchase, but only that they may be potential candidates for your own research.  Please read the prospectuses for any investments prior to making your own investments.)

Update:  In July 2015, Wisdom Tree converted the CHXF fund into CXSE China Ex-State-Owned Enterprises Fund.  See this article for details.)

Preview: The New Treasury Floating-Rate Note

floating-rate investment incomeFor bond investors who are  interested in variable-rate investments that increase interest payments as general interest rates rise, things should be getting a lot more interesting in the next few months.  The U.S. Treasury is scheduled to announce this month (November) the size of its initial January 2014 offering of new Floating-Rate Notes (FRNs). 


According to the Federal Register, the Treasury will be able to issue FRNs with maturities between one year and ten years.  The interest rate on these notes would effectively reset weekly based on the results from the weekly auction of 13-week Treasury bills.  The actual interest rates would be equal to the 13-week T-bill rate plus some “spread” amount.  Interest would accrue daily and be payable quarterly.  The Treasury is expected to issue no more than four FRNs per year.

Initial Offering

The initial January offering is expected to consist of $10-$15 billion of notes with 2-year maturities.  One of the key advantages of these notes is that they will have a minimum net yield of 0%.  This means that even if the Treasury allows T-bill auctions to result in negative interest rates, these notes will never be priced to reflect negative interest rates.  Individuals may purchase these notes through Treasury Direct with a $100 minimum. 


I am expecting these notes to be very popular, especially if interest rates drift higher.  Banks (including foreign central banks) and corporate cash investors will be the dominant buyers, but individuals seeking a safe alternative to commercial floating-rate notes will also be buying.  Holding these notes will be a popular alternative to rolling T-bills, which may incur significant transaction costs.  The high demand for these notes will likely lead to relatively low yields (probably just slightly higher than the T-bills).  Like other safe, but lower-yielding products, these notes will be excellent vehicles in which to park cash or to use to ensure preservation of capital in a rising-rate environment.  Unfortunately, at least initially, the rates will still be too low to be attractive to most income investors.  When interest rates are a little higher, and the Treasury offers longer maturity floating-rate securities, those will most certainly be smart investments for income.

Royalties for Income

royalty investments for incomeRoyalty investments, previously a domain only open to wealthier income investors, are becoming increasingly more accessible to ordinary investors.  Internet technology combined with more efficient financial markets has produced a win-win environment for the buying and selling of royalties.

Music Royalties

If you are attuned to popular culture, one of the more interesting possibilities for investing in royalties exists with the music industry.  Check out this article by Jasmine Birtles:

Make money by investing in royalties …

Oil and Gas Royalties

Oil and gas royalty trusts have traded on the stock exchanges for years.  One may, however, avoid the wall street commissions and overhead expenses that eat into an income stream by bypassing the royalty trusts altogether and purchasing royalty shares directly from producers and owners of oil and gas interests.  Royalty income obtained in this manner will invariably provide a higher yield (although less diversification may increase risk).  This is one area where you need to thoroughly understand what you are getting into before investing.  Due diligence and legal reviews are always a good idea.  One good site to find possible investments is  View the ads for Royalties for Sale.

Other Areas Not Quite Ready

Other industries where royalties are emerging as viable investment income streams are the pharmaceutical industry and the gold and silver mining industry.  Some pharmaceutical companies sell royalties for drugs they produce.  Unfortunately for the individual investor, most of these are purchased by large investors (Royalty Pharma, Cowen Healthcare, Paul Capital, DRI Capital) and other pharmaceuticals.  In precious metals mining, the gold and silver royalty “streamers” can be thought of as mining companies without the risks associated with the mining business (i.e., increasing operating expenses, union interference, litigation, environmental regulations, capital expenditures, and availability of capital or credit).  Their primary risk is the price of the underlying metal and, of course, macroeconomic factors like rising interest rates.  Gold royalty streamers include Franco-Nevada (FNV), Royal Gold (RGLD), and Sandstorm Gold (SAND).  A silver royalty streamer is Silver Wheaton (SLW).  These streamers have not significantly outperformed the GLD and SLV ETFs over the past year, so I cannot recommend them as smart investments for income at this time.  However, should economic and market conditions change, they may be worth considering.




Preferred Stocks Revisited – Select Income Opportunities

preferred stock investment incomeA while back, I posted something on the possible advantages of buying preferred stock ETFs versus individual preferred stock securities.  The tradeoff of receiving a slightly lesser yield in return for some personal time savings seemed worthwhile to me when interest rates were low and stable.  As we seem to have now entered a period when interest rates appear to be moving upward, I wanted to revisit my approach to preferred stocks to see if there might in fact be opportunities that may be better options than just holding ETFs.

Preferred stocks are fixed income vehicles that trade essentially like bonds.  There are different varieties of preferred stock, but in general they are similar to bonds in that they pay dividends at a fixed coupon rate.  Like bonds, the price movements of preferred stock are heavily correlated to changes in interest rates (not to the price of the common shares of an issuer).  Unlike a bond, a traditional preferred stock does not have a maturity date and is considered a perpetual security.  Preferred stock is also callable by the issuer after a certain date.  When preferred shares are called, the issuer buys back your shares at the par value of the security.  Some preferred stocks are “non-cumulative” in nature, meaning that if an issuer skips a dividend payment, there is no requirement to make up that payment later.  As you can see, there is significantly more risk with investing in preferred stocks than with bond investing, but the tradeoff is that the yields you get with preferred stocks are higher than what you can get with bonds.  On the risk/reward scale, preferred stock would rank higher up than bonds, but lower than dividend-paying common stocks, REITs, or MLPs.

Doing good research is especially important for investing in preferred stock.  If you intend to hold the stock for a long time, then you need to make sure the issuing company has a sustainable business and is in solid enough financial condition to continue paying dividends for that duration.  On the other hand, some investors just use preferred stocks as an alternative to bank CDs to park their cash in for a few years.  If you intend to eventually sell your preferred shares, then you also need to make sure that you purchase shares at a price where your expected returns are worth the risk and that a liquid market for the shares exists when it is time for you to sell.

In an environment in which interest rates are expected to rise, what is a good strategy for picking preferred stocks?  My first screen is always to look for preferred stocks that meet some basic criteria:

  1. Must be cumulative
  2. Must not be callable for at least 3 years
  3. Must offer relatively high yield
  4. Issuer must be in a strong financial condition with a good credit rating

To select individual securities that might outperform an index of preferreds, I then consider the current economic forecasts and how they would affect the securities that meet the above four criteria.  In general, when interest rates rise, they:

  1. Discourage companies from calling their preferred shares (so, I can probably consider securities with a shorter period before the call date than I otherwise would)
  2. Benefit bank and insurance businesses (strengthening their ability to sustain dividend payments)
  3. Favor real estate trusts that hold shorter-term leases (also making it more likely they will be able to sustain dividends)

 As I sifted through the various preferred securities using these guidelines, two securities caught my attention.

 From the insurance sector:

PRE-E:  PartnerRe Ltd, 7.25% Series E Cumulative Redeemable Preferred Shares (callable 6/1/16; current yield to call 4.9%)

 From the REIT sector:

PSA-OPublic Storage Inc., 6.875% Dep Shares Cumul Preferred Stock, Series O (callable 4/15/15; current yield to call 6.7%)

The yields for these securities compare to a current yield of 5.85% for PFF.  Both securities are still selling at a premium to their liquidation/call prices of $25, so they still seem a little pricey to me (especially PRE-E).  However, I am putting them on my watch list, and when interest rates move up enough that they start selling closer to par (or, better yet, at a discount), then I would seriously consider adding them to my income portfolio.   

 (Disclosure:  I do not currently own any of the securities mentioned, but may purchase them in the future. All yields are calculated based on closing prices on 7/12/13.  I am not recommending these securities as investments, only as potential securities for your own research.  Please read the prospectuses for anything prior to making your own investments.)