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Investment Opportunities

How to Earn a Safe 5.7% Yield

These are tough times for global income investors.

Bank accounts, CDs and money markets pay next to nothing. Treasury yields are at all-time lows. In Japan and parts of Europe, yields on even 20-year government bonds have gone negative for the first time ever.

All of these investments are likely to deliver a negative total return after inflation.

Worse still, many analysts expect interest rates to stay low for years.

So what is an investor seeking a decent, reliable source of income to do? You might start by considering investment-quality preferred stock.

Preferred shares are hybrid securities with the properties of both stocks and bonds. They generally carry no voting rights but have a dividend that has priority over the common stock. (Hence the “preferred” label.)

And in the event of a corporate liquidation, preferred shareholders stand ahead of holders of common stock, but are secondary to bond holders.

Like common stock dividends, preferred dividends are taxed at the more favorable 20% maximum tax rate – plus the 3.8% Obamacare surcharge.

That’s essentially half the top marginal tax rate – 39.6% – on interest-bearing securities. And if you want to be even more tax-efficient, own them in your qualified retirement plan where they can compound tax-deferred.

Preferreds are safer than common stocks, but don’t get me wrong. They still fell during the recent financial crisis. However, they dropped only two-thirds as much as the S&P 500 and rebounded more strongly during the recovery.

Like bonds, preferreds are interest-rate sensitive. When rates go up, prices go down.

Unlike bonds, however, these securities either will never mature or may not for as many as 50 years. So if interest rates rise, you could be holding lower-valued paper that a corporate issuer might not redeem.

At the same time, there is less upside potential with preferreds because the issuer typically has certain redemption rights. These generally include a “call” provision, where the issuer can buy out shareholders at face value five years after the issue date.

But here’s the real benefit: Preferreds are currently yielding around 5.7%. In today’s world, you would have to own fairly junky junk bonds to get that kind of yield.

There are two easy ways to own a diversified portfolio of preferreds. You could consider an exchange-traded fund like iShares U.S. Preferred Stock Index (NYSE: PFF), PowerShares Preferred (NYSE: PGX) or the riskier PowerShares Financial Preferred (NYSE: PGF).

Or you could consider a closed-end fund like Nuveen Preferred Income Opportunities Fund (NYSE: JPC) or Nuveen Preferred Securities Income Fund (NYSE: JPS). Both are liquid, sell at a slight discount to their net asset values and pay dividends monthly.

The expenses are higher with closed-end funds because they are actively managed and are able to use leverage to goose returns. The ETFs have lower expenses and are less volatile (since prices hew closer to net asset values).

Be sure to give a miss to closed-end preferred funds like Flaherty & Crumrine Preferred Securities Income Fund (NYSE: FFC) and Flaherty & Crumrine Preferred Income Opportunity (NYSE: PFO). Both trade at substantial premiums to their net asset value – a clear danger sign.

(Trust me, you don’t want to own a closed-end fund when it goes from a premium to a discount. And the way to avoid this is to never buy them when they are at a premium.)

Here’s the bottom line: With preferred shares you get an attractive yield, a more secure position than ordinary stockholders, more favorable tax treatment than with interest-bearing investments and less risk than common stocks.

In this yield-starved environment, they are an essential part of a well-diversified income portfolio.

Good investing,

Alex


About

An expert on momentum investing, value investing and investing based on insider activity, Alex worked as an investment advisor, research analyst and portfolio manager on Wall Street for 16 years. He now runs the wildly successful Oxford Communiqué, ranked as one of the top investment newsletters by Hulbert Digest for more than a decade. He is also the author of four national best-sellers: The Gone Fishin’ Portfolio, The Secret of Shelter Island, Beyond Wealth and An Embarrassment of Riches. He shares his wisdom in his free daily e-letter, Liberty Through Wealth.

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