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.)




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.