As investors near retirement, they tend to favor bonds, which provide income and less drama than stocks. However, less drama means less potential upside. With retirees living longer than ever before—which means much more time for inflation to eat away at your nest egg’s purchasing power—it’s important to not go too conservative too early in life. And fortunately, today even 65 or 70 may be too early.
One suggested solution for our long life expectancy “problem” is to stay with stocks longer. But stocks can go down as well as up, and a big pullback can inflict permanent damage on a portfolio.
So we want to capture the dividends that stocks pay and the upside potential that they provide by minimizing our downside risk. We can do this by focusing on hybrid stock/bond vehicles that are designed to extract payouts and provide downside buffers. Let’s focus on an underappreciated way to double your dividends from stocks that you may already own: preferred shares.
Not familiar with preferred shares? You’re not alone—most investors only consider “common” shares of stock when they look for income. You probably know the problem with this approach. Common stock in S&P 500 companies pays just 1.9% today, on average. But you can double your yields or better and actually reduce your risk by trading in your common shares for preferreds.
A company will issue preferred shares to raise capital, just as it offers bonds. In return it will pay regular dividends on these shares and, as the name suggests, preferred shareholders receive their payouts before common shares.
They typically get paid more, and even have a priority claim over common stock on the company’s earnings and assets in case something bad happens, like bankruptcy. They are “preferred” over common stock, and after secured debt, in the bankruptcy pecking order.
So far, so good. The tradeoff? Less upside. But in today’s expensive stock market—still pricey even after the late 2018 correction—that may not be a bad substitution to make. Let’s walk through a sample common-for-preferred exchange that would nearly double your current dividends with a simple trade-in.
As I write, the common shares from JPMorgan (NYSE:JPM) pay 2.8%. But the firm recently issued Series DD preferreds paying 5.75%. JPMorgan shareholders looking for more income may be happy to make this tradeoff.
Meanwhile, Bank of America (NYSE:BAC) common pays 2% today. But B of A just issued some preferreds that pay a fat 5.88%. That’s a 194% potential income raise for shareholders who want to trade in their garden-variety shares. But how exactly do we buy these as individual investors? Which series are we looking for again?
A big problem with preferred shares is that they are complicated to purchase without the help of a human broker. So, many investors attempt to streamline their online buys and simply purchase ETFs (exchange-traded funds) that specialize in preferreds, such as the PowerShares Preferred Portfolio (NYSE:PGX) and the iShares S&P Preferred Stock Index Fund (NASDAQ:PFF).
After all, these funds pay up to 5.9% and, in theory, they diversify your credit risk. Unfortunately, many ETF buyers have little understanding of preferred shares—let alone how a particular fund invests in them. Should we entrust the selection of preferred shares to a mere formula baked into an ETF?
No! The problem with the ETF model is that it doesn’t account for credit risk as accurately as an expert human can. Which means a better idea is—you guessed it!—to find an active manager to handpick your preferred your portfolio. Buying a discounted closed-end fund (CEF) is the best way to do this. Here are three preferred CEFs that have all outperformed their more popular ETF cousins over the past five years.