The market is doing no favors for fixed income investors at the moment. But one of my favorite funds, in one of the best cash niches out there, is a striking yield of 6.6% at today’s prices.
And he does it by owning some of Wall Street’s most boring, stable, and trusted stocks.
How do we bank that “free lunch” at 6.6% when the 10-year Treasuries again pay less than 2%? By tapping into an income stream that most individual investors rarely think about: the privileged.
The power of the privileged
If we wanted to own part of a business, say JPM
But just look beyond the common stocks, and this is where you’ll find the favorites.
Companies sometimes issue preferred shares instead of issuing bonds to raise cash. These preferred stocks typically pay dividends that take precedence over those paid on common stocks (a big advantage during a difficult economic time like this).
Another interesting advantage? Sometimes preferred dividends are “cumulative” – if dividends are missed, those dividends must still be paid before the dividends can be paid to other shareholders.
Best of all, these dividends are almost always juicier than the modest dividends paid on common stocks. A company whose common goods bring in 2%, or even 1%, could still distribute 5% to 7% to its privileged shareholders.
The downside to liens is that they behave much more like bonds, trading around a face value over time. But the chart above is missing a key element: dividends. Once you factor in the hefty income of the privileged, you get extremely attractive total returns with a fraction of the risk of the commons.
Remember: Preferred stocks can collapse just like common stocks, and in fact, some preferred stocks went the dodo path during the 2007-09 financial crisis. This is why second tier investors like us are doing the smart thing and buying privileged funds—Close those 5% to 7% returns while defeating our risk on dozens if not hundreds of problems.
Let me show you what I mean.
The best and worst ways to invest in preferred companies
Again, the 10-year T-note is earning 1.7%, but like most people, we buy our bonds through funds. Say we buy a medium term bond fund like iShares 7-10 Year Treasury Bond ETF (IEF)
This means that if you invest a million dollars in IEF, you would generate a meager annual income of $ 14,000.
If we go even further, say over 20 years, with the IShares 20+ Treasury Bond ETF (TLT)
Now let’s see what happens when you upgrade to favorites:
the IShares Preferred Securities and Income ETF (PFF)
All of these funds offer similar exposure, so we’ll use PFF as an example. The ETF holds more than 500 preferred securities, the majority of which (60% and more) are from financial institutions such as Wells Fargo (WFC
We get built-in diversification and a decent overall return of 0.46% (best of the trio, by the way). And out of all three, we have outperformed a standard bond index.
And we can do even better by thinking smaller.
Earn 6.6% with Preferred
If you’ve heard of a high yield AND F, chances are there is a better THIS F version just waiting to be discovered.
Closed-end funds are only a fraction of the exchange-traded fund market. They are usually actively managed, they can be more complex, and they can charge higher fees, which scares many newbie investors.
But if we choose our managers wisely, they will more than offset their costs.
Our “mystery” 6.6% return is none other than the Flaherty & Crumrine Dynamic Preferred and Income Fund (DFP). With assets of around $ 570 million, DFP is only a fraction of the ETFs just discussed. And because it’s in the unsexy world of CEFs, it’s not on your typical UKTN guest’s radar.
Too bad for them.
DFP’s managers have built a portfolio of around 170 stocks which, like most favorite funds, is heavy in financials, at 86% among banks, insurers and other industry names. Most of the favorites are clustered around the investment grade line, with 44% Baa rating (lowest rating) and 39% Ba rating (highest junk rating).
You also benefit from international diversification, which doesn’t hurt; the US is 70% of holdings, but you also get exposure to UK, France, Australia, and even Mexico.
The managers of Flaherty & Crumrine are what sets DFP apart from preferred ETFs, which are almost all index-based. Here, management has an advantage in that it can mine deep values in the preferred space that rule-based indexes simply cannot do anything about.
But management’s ability to use leverage to amplify their bets is also driving DFP’s high efficiency and strong performance. At the moment, DFP uses high leverage of 33%, which translates to more volatile returns than its ETF peers, but it’s hard to complain about the results.
Brett Owens is Chief Investment Strategist for Contradictory perspectives. For other great income ideas, get your free copy of his latest special report: Your early retirement portfolio: 7% dividends every month forever.