The election is out of the way, things look good for stocks, and most investors are probably feeling pretty confident right now. There is one group, however, for whom things are no better now than they were yesterday, or even a few years ago: income seekers.
Those who have done the right thing and saved and invested their entire lives have been punished the most by the last recession, and while things are improving slightly, the punishment continues. Most are looking for ways to juice their overall yield a bit, and that sometimes involves looking beyond just a portfolio of bonds.
Ultra-low interest rates made it almost impossible for most people to generate decent income from their investments for years, and now that rates are rising those same people are seeing the value of their holdings in bonds and other income products falling.
In an ideal world, they would be at least partly invested in something that generates a decent yield, but still stands to benefit to some degree from the economic strength that is driving stocks higher. Preferred stock may be the answer.
Preferreds, also known as preference shares, are shares that have some features not found in common stock. They have some characteristics associated with bonds, most notably interest payments, but still represent equity in the issuing corporation. The name comes from the fact that they are “preferred” over common stock when it comes to dividend payments and repayment of capital should the company be liquidated.
Bond and other debt holders would get paid first in such a scenario, but preferreds come next, ahead of regular stocks.
Technically, they do not pay interest as they don’t represent a loan, but they pay a dividend that is paid before any dividend on common stock and which is usually at a fixed percentage of the par value of the stock. That makes them more like bonds than common stock, and they are generally considered fixed income products.
As equity, however, they do vary in price based on market conditions and the prospects of the issuing company, although they tend to be less volatile.
As you may have guessed from the description above, preferreds are quite complicated instruments. In addition to multiple influences on price, and therefore yield, each has the potential to be different based on the terms of issuance contained in the articles of association.
Many, for example, have a call feature, allowing the issuer to redeem the shares at par under certain circumstances. Most investors therefore use funds to invest in the securities on the basis that the amount of research and expertise needed to properly assess them easily justifies the management fees. These days that is more likely to involve ETFs than mutual funds.
The largest ETF in the field is the iShares U.S. Preferred Stock Fund (PFF), but for those prepared to take a little more risk there may be a better answer in the Virtus InfraCap U.S. Preferred Fund (PFFA). The additional risk comes largely from the fact that this fund employees some leverage and options strategies to increase yield, but that is offset by the fact that PFFA is actively managed rather than just tracking an index.
Given the complexities inherent in preferred stock, that is an advantage, as long as the fund manager knows their stuff.
In this case, the CIO of InfraCap, Jay Hatfield is the fund manager, who has over thirty years of industry experience with a specialization in income products. I spoke to Jay recently to ask him about PFFA. He and I agreed that even with the Fed on a path to higher rates, yields further out on the curve look like remaining range-bound for some time. That makes the enhanced yield that PFFA offers attractive to those who need income.
He pointed out that securities are selected for the fund based on its own research and criteria, and that the roughly 25% leverage and options strategies employed have been successful so far.
PFFA is still a young fund, having been launched in May of this year, so it is a small sample size, but since inception it has outperformed the far bigger PFF by 125 basis points. The dividend is paid monthly, and to date has been $0.19 per month. It is too early to calculate an official yield but is that is maintained it will represent a trailing yield at yesterday’s close of 9.23%.
I should stress that a fund like PFFA should be used as an addition to a more traditional fixed income portfolio rather than a place for your entire account. Preferreds do have higher risk than bonds and are more volatile. That volatility though, is part of the appeal right now. It is less pronounced than for regular stocks, but does allow for some capital appreciation, even in an environment of gradually rising rates.
Given that, and the high yield PFFA offers, it is a fund that should be considered by those looking to juice the yield of their portfolio.