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This 'Perfect' Investment Has Bond-Like Safety and Stock-Like UpsideBy
Wednesday, May 11, 2016
I like to call it the "perfect income investment."
The majority of individual investors have never even heard of this investment, but it's popular with sophisticated investors... the kind that manage billions of dollars.
This investment has the safety of a bond. It pays regular income. But it's better than a bond... because it has the upside of stocks.
Today, I'll tell you all about this opportunity – which pays a little more than 7% right now. And again, it has the safety of a bond and the upside potential of a stock... That's why I often call it the "perfect income investment." Even better, you can buy it through your broker with a single click of the mouse. Here are the details...
When most folks think of investing, they think of either stocks, which provide the potential for capital gains, or bonds, which provide safe and steady fixed income.
Both can be valuable additions to any income investor's portfolio. And it turns out that you don't necessarily have to choose between the two. There's actually one area of the market where you can combine the safety of a bond with the capital-gains upside of a stock...
When you hold a stock, you own a small part of a business. If the business does well, its owners – the shareholders – should profit, through rising share prices and dividends. Of course, the company can decide to reduce or eliminate its dividend when it's not doing well, which directly hurts investors' portfolios.
On the other hand, bondholders don't own a stake in a business. They are simply making a loan to a company. The company pays bondholders a predetermined interest payment for the duration of the bond. At the end of the bond's life, the company pays back the original loan. If the business grows and makes more money, bondholders don't get higher returns.
The interest payments on a bond are non-negotiable. If a company misses an interest payment, it's in big trouble. It has violated a legal contract... and creditors can declare it in default. Bankruptcy could be looming.
You may be wondering... what kind of investment combines bond-like safety with a stock's potential for capital gains?
I'm talking about preferred shares, or "preferreds."
When a company issues preferred shares, its shareholders are considered part-owners. The price of preferred shares can rise or fall based on the market's perception.
Because of these qualities, preferreds are considered equity rather than debt. So companies benefit from issuing them by keeping their debt levels lower... plus maintaining a little more flexibility than they get by issuing bonds.
And investors benefit because preferred dividends are reliable. They aren't as certain as bond interest payments, but they are much more certain than typical stock dividends.
A company is contractually obligated to pay its preferred dividends before it can pay dividends to common shareholders. A dividend-paying stock would have to cut its dividend to zero before reducing its preferred payments by a cent. Companies don't frequently reduce or eliminate their dividends. That's one advantage of investing in preferreds.
Another bonus for preferred shareholders... Most preferred dividends are cumulative. That means if a company can't pay its preferred dividends, it has to pay back any missed preferred dividends before it can pay regular dividends to common shareholders.
When you invest in high-quality companies, these things rarely happen. So you can see why preferreds have an added level of safety.
Also, if a company increases its earnings, it can continue to raise its common dividend. With preferred shares, the dividend is predetermined – much like a bond payment.
Of course, there is a tradeoff in buying preferred shares...
While they pay high, safe dividends, the potential for capital gains is lower than that of a common stock. The share price of a preferred stock is unlikely to rise much, even if a company is successful. That's because most preferred shares are "callable."
When a company issues preferred shares, it usually offers them at a price of $25 per share (called "par"). During the life of the shares, the price can fluctuate, but preferreds have a specific end date – usually five years. After the five years are up, the company can buy back – or "call" – its preferreds at a price of $25. So while preferred shares can fluctuate, prices don't typically stray too far from $25.
It's foolish to buy preferreds for $30 if they could get called away at $25, although occasionally their high yields make buying preferreds trading above par worth the risk. Meanwhile, a preferred trading at $20 has the potential to return 25%, should it get called away.
You can see why the price of preferreds rarely drifts too much. We aren't looking for big capital gains. We're here to collect the big streams of income.
In the end, preferreds offer safer dividends than stocks and higher returns than bonds.
But rather than investing in the preferred shares of a single company, I recommend balancing your portfolio with a "one click" preferred-shares fund, such as the Nuveen Preferred Securities Income Fund (JPS).
JPS is a closed-end fund that holds mostly investment-grade preferred shares. Because the fund uses some leverage (30%), it's able to pay a 7.7% annual dividend – in monthly installments.
As a closed-end fund, JPS raised money at its launch, which it manages to produce income. JPS shares now trade on the NYSE and fluctuate in price. Sometimes it is overvalued or undervalued based on its "net asset value" – or the real value of JPS' holdings.
Right now, JPS sells for a slight 3.1% discount to its NAV. This means you're getting a dollar of assets for about $0.97. This small discount gives us an added level of safety.
Nuveen recently reorganized and renamed the JPS fund. So you may still see it show up under its old name as the Nuveen Quality Preferred Income Fund 2. And some sites show its dividend yield as 1.6%. But that's an accounting quirk... the yield will still be in the high 7% range.
Since I began recommending JPS in my Income Intelligence newsletter in July 2013, shares are up 5%, but after including dividends, our total position is up nearly 30%. That's the power of diversifying your income portfolio with another safe income stream.
And as expected, preferred shares declined with the market's recent correction, but held their value better than regular stocks. That's the stability that attracts us to preferreds, in action.
If you haven't considered investing in preferreds, take a look at JPS today.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig
Further Reading:
Get more of Doc's best income advice here...
"Stocks move up and down. And you can't control or predict what they'll do from day to day," Doc writes. "But by remembering these three trading principles and sticking to a smart strategy, you can turn even down moves into profits."
"Which strategy should you be using if the market provides flat or negative returns in 2016?"
Market NotesA NEW BREAKOUT IN "BORING" Today's chart offers an important reminder that "boring" often means big money in the stock market...
Longtime readers know we're fans of simple businesses. Contrary to popular belief, you don't need to invest in complicated businesses to make money. Companies that "sell the basics" frequently make great long-term investments.
One of the best examples is Clorox (CLX). Most people associate Clorox with cleaning supplies... but over the years, the company has acquired a diversified portfolio of household brands. Some you may recognize include Brita water filters, Kingsford charcoal, Hidden Valley salad dressing, K.C. Masterpiece barbecue sauces, Glad trash bags, and even Burt's Bees skincare products.
Selling the basics has made Clorox a cash-flow machine. The company has paid and increased its dividend each year since 1978. As you can see below, its share price has been increasing, too. Shares are up almost 50% in just the last two years. And yesterday, Clorox hit a fresh all-time high. It's more proof that selling the basics isn't exciting... but it works.
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