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.)




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.)



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.)

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.)

Best REITs for Rising Interest Rates

real estate investmentReal Estate Investment Trusts (REITs), like master limited partnerships, have long been a staple of income portfolios.  Because they are required by law to pay out 90 percent of their earnings as dividends, they can provide investors with high yields.  Since 2009, the price of equity REITs has more than doubled due to demand from yield-hungry investors who have been faced with a low interest-rate environment.

A downside of investing in REITs is that they are generally very sensitive to interest rate increases.  Since most of their earnings are distributed as dividends, REITs do not keep much cash on hand, so they have an ongoing need to raise cash by borrowing money or selling shares.  When interest rates rise, their cost of capital also rises cutting into their earnings.  The spectre of rising interest rates hit the markets hard in May, and from May 21 to June 21 the market value of equity REITs declined by about 16 percent.

So given the likelihood that interest rates will probably be rising in the next few years, which REITs should be avoided and which ones might still offer opportunities?

I would suggest avoiding those REITs that are saddled with long-term leases.  Owning such REITs is comparable to owning bonds – they provide steady and reliable cash flow through rents, but as inflation picks up and interest rates rise, the REITs cannot make appropriate rent adjustments to cover increased capital costs (and, of course, dividends may suffer).  Examples of business types with long-term leases include landlords of single-tenant (triple net-lease) properties and most healthcare REITs.  The one exception I would make here is if you come upon any REITs that issue leases with rent escalators rather than fixed rents.  Those might still be worth investigating.

The REITs that may prove to be smart investments for income would be those that hold relatively short-term leases. In particular, I would explore multi-family REITs and self-storage REITs.


Multi-family Residential REITs

Multi-family (apartment) REITs have underperformed other REITs lately.  An improving housing market and the number of new apartments coming onto the markets have scared many potential investors away.  However, as the economy improves, these REITs are poised for a comeback.  An improving economy means more jobs, which directly impacts these REITs by increasing the number of potential tenants.  As interest rates rise, building of new apartments is also expected to drop off significantly, thus allowing current landlords more flexibility to increase the rents of existing residents.

Two popular multi-family REITs to investigate are:

Equity Residential (EQR, yield 2.8%)
AvalonBay Communities, Inc. (AVB, yield 3.2%)

Another possibility within this sector is with a student housing REIT:

American Campus Communities (ACC, yield 3.6%)


Self-Storage REITs

The self-storage industry consists of about 55,000 properties nationwide.  Some people consider the industry to be a somewhat counter-cyclical, i.e., a troubled economy = increased need for storage.  The industry is currently experiencing record-high occupancy rates of around 90 percent, and landlords have been raising rents 5 percent or higher on existing tenants over the past couple of years.

Self-storage operators are benefiting from low competition because supply is tight.  There are only about 200 self-storage facilities currently under construction nationwide.  This compares with over 2,500 facilities developed between 2003 and 2007.  High valuations for self-storage properties are likely to persist until there is another wave of development that saturates the market.

Three popular self-storage REITs to investigate are:

Public Storage (PSA, yield 3.3%)
Extra Space Storage, Inc. (EXR, yield 3.8%)
CubeSmart (CUBE, yield 2.7%)

Please be sure to conduct your own due diligence on any of the REITs mentioned in this post before investing.  I am not recommending these as investments, only as possibilities to explore.  (Disclosure: I own none of the REITs mentioned in this post, but may purchase one or more of them after doing more exhaustive analysis over the next week.)



Are MLPs the Perfect Income Investment?

MLP Master Limited PartnershipMaster Limited Partnerships (MLPs) have been popular investments for income portfolios for the past couple decades, but over the past year there has been a noticeable push to promote these investments to a greater number of individual investors.  Everyone from Jim Cramer to Barron’s to the Motley Fool seem to have concluded that owning partnership units are the closest thing to a perfect investment as one can make for an income portfolio.  But are these investments too good to be true?

The basics of MLPs are explained pretty well at Investopedia and others websites.  The MLP world consists primarily of groups engaged in natural resource activities, notably oil and gas pipeline operations.  Because of the way they are structured and the tax-favored treatment they receive, MLPs are able to offer investors attractive high-yield returns.  Unlike regular dividends, the distributions from MLPs are treated as a combination of income and return of capital.  Many investors (myself included) are turned off by the paperwork and recordkeeping needed for tax purposes.  Partnerships are considered pass-through entities, so, as a unitholder, you are obligated to pay your share of the taxes for a partnership’s income.  Instead of 1099s, you would receive K-1 forms annually for your holdings.  The recordkeeping becomes even more involved if you hold these investments in a retirement account.  Understand the tax implications before investing in these entities. 

MLPs have bounced back nicely from the 2008 debacle, and earlier this month they actually looked overpriced.  Over the past week though (I’m writing this in late-May 2013), there has been a significant correction in the sector, so prices appear a little more palatable.  As with any high-yielding investment, these investments are sensitive to interest rate changes, so I would advise watching these investments closely going forward.

One way to bypass the tax headaches for these investments would be to invest in an MLP fund or ETF like AMLP or EMLP.  Before investing, I would run the numbers to make sure the fund expenses and fees are worth the return and income you are seeking.  If they are, then these may be smart investments for your income portfolio.

The Case for Equity Income Investments

Dividend incomeThe author Richard Stooker makes a compelling case for building portfolio income through equity investments. Although he comes down pretty hard against growth investing, the prudent investor will probably have no problem at all with the idea that at least some significant part of one’s portfolio should be devoted to current income production through equities. Stooker’s book is pretty good. Look for a link to it somewhere on this website. The following is from one of his articles:

Investing for Income — FAQ for Ordinary Investors

1. Dividends are so low, they’re a joke. Why should I invest for such a small return on my money?

If you buy only stocks in the Mergent index, you’ll get quality companies that have raised their dividends every year for at least 10 years — some of them for over 100 years.

Besides, dividends are no longer as small as they were during the peak of the dot com boom when the average S&P 500 stock paid under 1%. Thanks to the low stock market, you can pick up stocks that pay up to 8% or more.

2. What kinds of stock offer such high returns?

Brand name consumer stocks aren’t quite that high, but offer dependability and safety — such as Coca-Cola and McDonalds. Real estate investment trusts (REITs) are required to pay out over 90% of their cash. So are master limited partnerships (MLPs) — which transport oil and natural gas through pipelines. Utility companies are the traditional widows and orphans stocks, because they pay dividends and are so safe.

3. What if the economy goes into another Great Depression?

Every company would suffer, no doubt about it. And people would not be able to pay higher rents, they wouldn’t use as much electricity and they wouldn’t go out to eat as much. Companies that pay dividends might have to reduce them, or not raise them as much as they’d like.

However, unless a universal catastrophe sends the entire world back to the Stone Age (and if that happens, you won’t care about your stock portfolio’s performance anyway), people are still going to turn on electric lights, chew gum and buy hamburgers.

4. Everybody says that when you buy a stock and its price goes down, you’ve lost money. How can I avoid losing money?

Any stock you buy could go down in price at any time. Income investors don’t have to care, because they still receive quarterly checks.

5. Why shouldn’t I just put my money into an index fund?

If you insist on investing for capital gains, that’s the smartest way to do it. You can’t pick individual winners, so go with the broad market. However, index fund holders gained nothing from 1999 to mid-2008. And the future doesn’t look any better. Here’re some bad signs for the future:

1. Rising oil and other energy prices — with political unrest, war and possible war with Iran threatening to move the price of oil even higher.

2. Rising gold and silver prices.

3. The sinking U.S. dollar.

4. The baby boomer generation has started to retire, which will place enormous strains on the Social Security and Medicare trust funds, take experienced labor out of the economy and depress stock and bond prices as they sell off their portfolios.

5. Terrorists still want to convert the entire world to their version of Islam.

Index fund advocates say that in the long run the market will go up because our capitalist economy creates wealth. I support the sentiment, because I strongly support capitalism. I just don’t see any guarantees from God that capitalism will triumph, or that human progress has to continue.

We’ve seen a lot of scientific advancement, social progress and wealth creation over the past 500 years. But we’ve also seen periods of human history, such as the fall of the Roman Empire, where previous gains were erased — for hundreds of years.

If the terrorists succeed in setting off a nuclear bomb, it could be many decades before the U.S. stock market can rise above current levels.

I’m not going to say this is going to happen, but none of us has any guarantee it won’t.

6. Dividends are only for rich people who inherited a bunch of stock. I need to get rich in a hurry.

It’s true that you’re not going to receive a million dollars a year in dividend income unless you’re starting out with at least $20 million. However, investing is not — and never has been — a way to get rich quick. People who try it usually lose their money.

If you want to speed up the process, you must start a business of your own that solves problems for many people. If you think they’re shortcuts to such success, you’ll lose your money to the many con artists that prey on people like you.

7. The stock market is so low, and may go lower — I’m afraid of it. What should I do?

Realize that this is the best income investing opportunity to come along in a long time. Because stock prices are so low, there’re many opportunities to pick up brand names, utilities, Canadian income trusts, master limited partnerships and real estate investment trusts at bargain prices.

Now is the best time in years to lock in high — and ever-growing — dividend yields.


With today’s financial markets as uncertain and unstable as they are, traditional buy and hold, and pick winning stocks, strategies don’t promise much return. You must rely on luck, and that’s not reliable over the long term. Stocks have gone nowhere since 1999. Yet people who invest for income have received regular quarterly dividends.

Best Ways to Get Income From Preferred Stock

preferred stock incomeJust as I don’t believe in holding the common shares of only one company in my portfolio, I don’t believe in buying the preferred stock of just one or two companies either. The more you rely on an income stream from preferred stock, the more reason you have to be mindful of diversifying to minimize risk. The down side of diversification for most individual investors, however, is the need to do a lot of research. I, for one, am willing to forgo a little (very little) return in order to save some personal time and not have to do so much research. If you are of the same mind, then maybe you should consider investing in preferred stock ETFs.

Unlike bond funds, which I generally don’t care for, the yields for some preferred stock ETFs are currently high enough that you actually do okay even after fund expenses are subtracted. If you can stand the high volatility usually associated with closed-end high-yield funds, you can start exploring these investment options by taking a look at these:

iShares S&P U.S. Preferred Stock Index (PFF), yield 5.89%

PowerShares Preferred ETF (PGX), yield 6.44%

SPDR Wells Fargo Preferred Stock (PSK), yield 6.3%

The holdings of all three of these funds are heavily weighted towards the financial sector, so if that makes your stomach turn, it’s probably a good idea for you to look elsewhere.