Brett Owens, Chief Investment Strategist
Updated: November 10, 2023
The Fed “pause” is on—and that means we’re this much closer to the first rate cut since the COVID-caused race to zero.
It’ll soon be “game on” for fixed income of all sorts. And that includes one class of stock that has been kicked deep into value territory—giving us a potential one-two punch of high income (6.9% to 9.2% yields) and a violent bounce off the bottom.
More on these sweet payouts in just a second.
A High-Yield Way to Ride Powell’s Coattails
Federal Reserve Chair Jerome Powell and his henchmen at the central bank recently made the call to keep the benchmark fed funds rate level—a clear acknowledgement that the economy is indeed slowing.
The next step in this dance is a recession. At that point, you should expect the Fed to flip and send interest rates in reverse.
When that happens, discarded fixed income will finally have its day.
I like several areas of fixed income right now, but one opportunity that might be ripest at present is preferred stocks, which have become attractively priced thanks to a nearly two-year bear market. Their income potential is simply spectacular:
I love preferred stocks because they combine several factors of both stocks and bonds to create a powerful combo equity. For instance, like common stocks, preferred stocks trade on an exchange and represent equity in the issuing company.
But like bonds, preferreds typically don’t trade violently up and down—instead, they trade around a par value. They also usually don’t provide voting rights. And while preferred stocks pay dividends, the amount of income they pay remains fixed.
They also offer a few unique perks, including:
- “Preference”: Preferred dividends have “preference” over common stock (hence the name). A company has to pay preferred dividends before it pays common-stock dividends. If it wants to cut the preferred dividend, it has to cut the common-stock dividend first. In practice, it’s not much—but it’s a welcome sliver of extra protection against having your dividends cut or suspended.
- Cumulative dividends: Some preferred stocks pay “cumulative” dividends. In other words, the company not only has to pay dividends on its preferred stocks before common stockholders get theirs—if it misses a preferred dividend payment, it has to catch up on that payment first, too.
- Big, fat yields. Capital gains are very much secondary here—the appeal of preferreds are their dividends, which tend to be much more generous than the payouts on their respective common shares.
While I do occasionally dabble in individual preferred stocks, most investors are better off buying a diversified bucket of them via funds. Like bonds, preferreds also are extremely difficult for individual investors to value and analyze due to little data and even less news and analysis.
If you really want to turbo-charge your preferred returns, consider closed-end funds (CEFs). While you can buy preferred mutual funds and exchange-traded funds (ETFs), preferred CEFs benefit from agile active management, the ability to use debt leverage (which can juice returns and yields), and the possibility of buying funds at a discount to their net asset value (NAV).
Case in point: I’m going to introduce you to three preferred-stock CEFs that are yielding a fat 8.4% on average at present.
Nuveen Preferred & Income Term Fund (JPI)
Distribution Rate: 6.9%
I want to start with the Nuveen Preferred & Income Term Fund (JPI), which is a pretty straightforward preferred-stock play, but with a couple twists and turns.
JPI’s portfolio typically has to invest at least 80% of assets in preferred stocks and other income-producing securities—while that’s a wide net, management typically sticks to preferreds and convertible securities.
Similar to most preferred funds, JPI is beholden to the financial sector. Indeed, its top five industries—which collectively make up 80% of assets—all belong to the sector: diversified and regional banks, insurance, capital markets, and financial services.
Credit quality is unremarkable, but I’ll point out that it is better than the ETF benchmark, the iShares Preferred and Income Securities ETF (PFF). Some 70% of JPI’s preferreds are investment-grade; it’s less than 55% for PFF.
JPI’s twist and turns come from its nature as a closed-end fund.
It has management, which can be flexible—that compares to virtually all preferred ETFs, which are tethered to a restrictive index. It uses leverage—a ton of it, in fact. Current leverage of 37% is extremely high; CEFs rarely eclipse 40%. And it trades at a 6% discount to NAV that, while not scintillating, is twice as deep as its five-year average discount (3%).
You’re also getting a fund that has outperformed PFF over the long haul.
This Is What You Want to See From Active Management
Despite all this, JPI isn’t a total home run.
For one, you can simply look at the chart and tell that JPI isn’t nearly as calm as your traditional preferred fund—all that leverage makes it jumpy, which means while you might be getting better long-term performance, you’re getting a lot more short-term volatility. (And for many investors, lower volatility is one of the perks of preferreds.)
You won’t be able to hold JPI for very long, anyways. This is a term fund whose time will end next summer—on or before Aug. 31, 2024, the fund will liquidate and distribute its net assets to shareholders.
Lastly, let’s look at JPI’s distribution:
A 42% Decline in Income Is a Rough Way to Reward Long-Term Holders
It’s not uncommon for preferred-stock fund dividends to change over time, and preferred-stock CEF distributions in general have shrunk over the past few years. But JPI’s income “shrinkage” is something to behold. So, let’s look at two other funds whose payouts aren’t hemorrhaging ground.
Cohen & Steers Limited Duration Preferred and Income Fund (LDP)
Distribution Rate: 9.0%
The Cohen & Steers Limited Duration Preferred and Income Fund (LDP) is a little quirky. It holds preferreds, sure, but it’s a “limited-duration” fund. Most preferred stocks are perpetual in nature, which means they don’t really have a duration. But LDP selects from preferred stocks that do have expiration dates (and thus durations), and it buys preferreds whose durations are on the shorter side. The average modified duration of Morningstar’s preferred stock fund category is over 8 years; LDP’s is a hair over 3.
So, LDP has a slightly better credit profile than iShares’ preferred ETF and it sticks to shorter-duration issues, which in theory should depress its income-generating ability—but thanks to a hefty use of leverage, this Nuveen CEF can offer up a 9% yield.
It also trades at a fat 10% discount that’s 3x its historical rate, and it too has historically outrun the benchmark.
LDP Is Another High-Performance (But High-Volatility) Preferred Fund
Cohen & Steers Tax-Advantaged Preferred Securities and Income Fund (PTA)
Distribution Rate: 9.2%
The trio’s biggest yield belongs to another CS fund: the Cohen & Steers Tax-Advantaged Preferred Securities and Income Fund (PTA).
It’s also the youngest of the three, having come to life in October 2020. But in its short publicly traded life, it’s also the worst-performing:
Other Preferred Funds School PTA
But why?
Despite what you might assume from the “tax-advantaged” in PTA’s name, there’s nothing terribly special about the fund’s goals. The CEF attempts to “achieve favorable after-tax returns for its shareholders by seeking to minimize the U.S. federal income tax consequences on income generated by the Fund.” And it accomplishes that in two ways:
- Invest in preferreds that pay qualified dividends.Easy enough. Many preferreds already pay qualified dividends.
- Achieve favorable tax treatment by holding longer.PTA is being mindful of locking up favorable long-term capital gains rates. Of course, a lot of preferred funds don’t exactly day-trade their holdings.
The resulting portfolio is pretty cut-and-dry, too. PTA’s roughly 240 preferreds are predominantly from the financial sector. There is quite a bit of international exposure, though—about 40% of assets are preferreds from Canada, France, the U.K., and other places outside the U.S., which is about 10-15 points more ex-U.S. exposure than your typical preferred fund.
Credit quality is a little low, though; less than half of assets are investment-grade. And leverage is high at nearly 40%.
The result has been a volatile and disappointing first three years for PTA’s managers, who have little to show for their “tax-advantaged” focus. So despite a high yield and a decent 7% discount to NAV, there’s not much to get excited about here.
I’m Going to Retire on Dividends Alone—And You Can, Too
The “4% rule” is dead.
Don’t believe me. Believe William Bengen, the MIT grad who developed the 4% rule nearly three decades ago!
Bengen isn’t exactly on Easy Street these days. In fact, he’s nine years into retirement and conceded to the Wall Street Journal that he’s “not comfortable.” (In fact, he said he’s cutting back on restaurants!)
My advice to you, and Billy for that matter, is to ditch that 50/50 blend of stocks and bonds and get creative—just like we’re doing in my massive-yielding “No Withdrawal” portfolio.
We don’t limit ourselves to a bland mix of conventional stocks and bonds. We look for opportunities in a wide variety of investments that are under-covered and overlooked—despite massive yields on stocks and funds of 8%, 9%, even 10%-plus. In fact, the top 10 payers in our live portfolio are yielding 11.8%!
That’s $118,000 in yearly dividend income on a million-dollar nest egg!
With that much income, you won’t have to touch a nickel in your retirement account. Just sit back, relax, and routinely keep your eye on the mailbox for when your fat dividend checks arrive.
Don’t let your retirement plan fall short as soon as you’ve crossed the finish line. Click here to learn more about my No Withdrawal portfolio!
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