With 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.)