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austinhippie (82.37)

Arithmetic in deed - Preferred are Better than Bonds!

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September 08, 2012 – Comments (6) | RELATED TICKERS: WLFCP , CMG , REX

     Preferred stock seems far superior to me over bonds for the conservative portion of a person’s portfolio.  The other night in his DNC Convention Acceptance Speech, President Obama urged people to consider some basic arithmetic, as had his cohort, President Clinton, the night before.  I recommend carrying that sentiment over your own portfolio. 

     Lately, I have been thinking a lot about portfolio allocation.  And I am coming up on one of those birthdays around which most financial advisors start to recommend a slight step up in the conservative portion of a portfolio - the portion usually filled with bonds.  But personally, I can’t stomach the dismal or even negative returns of bonds in comparison to inflation and in comparison to the rest of my portfolio.  I just can’t make myself do it.  I’d rather save up enough and structure my payout mechanism in my retirement portfolio so that I don’t ever have to own the lowly structures.

     Enter – Preferred Stock.  So apparently only 4% of preferred issues are owned by individual investors.  Why?  Because we have heard that they are not tax efficient for regular investors like they are for corporations and that most of them don’t qualify for the 15% tax rate that interests us.  Okay – let’s take that second point.  Put the funds that would be inefficient into a non-taxable or tax-deferred account, like an IRA.  Problem solved.

     Now for the first point – that they aren’t tax efficient.  Actually, some do qualify for the 15% tax rate.  However, let’s get beyond that.  I am in the 25% tax bracket.  If my goals for this part of my portfolio are to hold something conservative, without a lot of market fluctuation, and to have something that actually beats inflation but doesn’t have the smallest returns possible to beat it, then preferred stock is a far superior choice over bonds, even if I have to pay my regular tax rate on that portion of my annual earnings from the preferred stock.

     Let’s do the math.  Preferred stock is bought and sold in lots of 100 shares at a time, like options, and usually is sold at $25.00.  Let’s say I buy 1000 shares of company XYZ preferred stock at a slight premium.  I buy 1000 of ticker XYZpA (or at some brokerages XYZprA) at $25.12 for a total purchase price or $25,120.  The yield at $25.00 is 8% paid on a quarterly basis (although there are some good choices with high yields that payout on a monthly basis as well) so it will pay out $.50/share/quarter or slightly less than 8% since I paid a small premium.  Some preferred stock is callable, like bonds.  But in most cases, that $.50 / share / quarter will remain constant into the foreseeable future.

     In this case, my Annual earnings from this will be $2,000 – much better than the best offers for certificates of deposit on bonds that I have found lately.  If this was in a tax-deferred or non-taxable account, then all of that would be mine to use.  If it were in a taxable account, and it qualified for the 15% tax rate, as is common with non-cumulative preferreds, then my tax bill would be, $300 and I would still have $1700 to use as I wish, an effective return rate of 6.8% - not bad!  And better than bonds – by far.

     Now let’s assume that I hold a cumulative preferred issue, which usually doesn’t qualify for the 15% tax rate, or worse yet, that the 15% tax rate is done away with as is proposed for 2013.  With that assumption, my tax bill would be charged at my regular 25% tax rate.  I would still make $2,000.  Then I would owe, $500, an effective return rate of 6 %.   This would leave me with $1500 to use as I wish.   That still sounds reasonable to me. 

     Am I missing something here?  So far, I don’t understand why other individual investors don’t tread here more frequently. What do you think about these portfolio allocation goals for someone with a very long time horizon and a total annual return of 2+% above SPY?  Assume that less tax efficient issues are held in tax-deferred or non-taxable accounts.

A)  20% preferred stock position – 5 – 10 issues - still learning about these

B)  20% - 40% micro and small cap stocks – 10 to 20 issues

C)  20% - 40% stocks for long-term holding – these can be significantly overweight

D)  20% cash and/or deep value stocks for flipping* – these can be overweight too

     Some examples from each category

A)  recently bought WLFCP and HIGpA in non-taxable account and BMLpQ and JPMpI in taxable accounts

B)  bought some REX, VOXX and MIND recently

C)  bought CMG after its most recent earnings report – long-term hold in taxable account, bought some SBUX in dividend accumulating taxable account and also in my non-taxable account, TOT

D)  bought CMG after its most recent earnings report, sold it the other day in my non-taxable account

6 Comments – Post Your Own

#1) On September 08, 2012 at 6:11 PM, somrh (85.96) wrote:

I guess I'm partly curious how well they correlate with junk bonds. Here's a look at JNK and PFF.

It looks like there's a slight lag (significant) and a larger drawdown (perhaps due to overweight of financials?).

I haven't done much research into preferreds (the above is just a conjecture of mine). Obviously if you have high grade preferred shares that aren't likely to default, you get better yield. But on the off chance that it defaults you're SOL as the bonds are senior to the preferreds.

The callable element makes things more difficult as well. Are the preferreds callable at par? If so, by paying a premium you're taking a huge risk there. 

This looks like it might be an interesting read (I've only skimmed it).

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#2) On September 08, 2012 at 8:43 PM, austinhippie (82.37) wrote:

Thanks for the link and for your perspective. It is possible that investor's knowledge that the status rank in the order of who gets paid in case of a liquidation of assets is responsible for those investors choosing to put their money in bonds.  But I suspect that there is a lot of behavior based on habit and lack of knowledge of preferreds.  People are so affraid of their finances that they don't delve in.  And, frankly a lot of them just don't feel like they have the time to do the due dilligence on these shares.  So it makes sense to go with the status quo for them.  

Most preferreds are callable at par value a certain number of years after the IPO. But some are perpetual and others are callable but the company chooses to continue paying out the dividends rather than buying back the shares.

Thanks again for your perspective and for sharing the link to that paper - interesting stuff.  I still feel better owning those financial preferred stock over the common for the ones I have in my portfolio, but, to each her own. 

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#3) On September 09, 2012 at 12:34 AM, awallejr (82.72) wrote:

I urge you to consider MLPs.  Low beta, high distribution rates, unique tax advantage especially if you are a true long term holder.  You can even rinse out and in effect reset the capital gains by selling them against any accumulated annual losses and repurchase after 30 days.

A link to consider:

 http://caps.fool.com/Blogs/splitsville/758853

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#4) On September 09, 2012 at 10:01 AM, austinhippie (82.37) wrote:

Thanks for the link.  I really appreciate how you share your experience with others.  You mentioned in one of your blog entries that you sold some of your unit shares.  If I ever bought an MLP, I would have the intention of holding it forever but, there are circumstances for every investment that can mean it is time to sell.  How long did it take you to deal with the taxes on that?  Was your brokerage helpful to you or did you have to do all of the figuring yourself?   I have thought about MLPs, but kind of like my old attitude toward preferreds, I just stayed away.  In part, I have stayed away because I am not sure about these questions.  Thanks,

Elisabeth 

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#5) On September 09, 2012 at 5:31 PM, awallejr (82.72) wrote:

Turbotax makes handling the K-1s easy.  Unfortunately you don't start getting them until March so either you file near April 15 or you get an extension.  So far I have always been able to file by April 15 the latest.

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#6) On September 09, 2012 at 8:00 PM, rd80 (98.66) wrote:

I share your pain on reaching the age where the rules of thumb say it's time to start getting safe, but the traditional safe stuff doesn't look very safe when interest rate risk is rolled in.   

I haven't looked into preferreds in any depth, but two ETFs holding preferreds turned up in a (shameless self promotion) search for yield article I did for the Fool a little while ago. The key risks seemed to be taking a step lower in a company's capital structure, call risk since ultra-low rates on everything else have most preferreds trading at a premium, and interest rate risk.

I second awallejr's recommendation to look in to MLPs for some of the yield piece of a portfolio.  Many of them have had the prices bid up quite a bit recently, but I believe you can still find some at reasonable prices.  I own one and the online tax software I've been using takes care of the K-1 information with no hiccups. The 'return of capital' will catch up with us at some point, but until it does the tax advantages are sweet.

Andy - thanks for the splitsville shoutout and thanks for tacking on the detailed MLP comment.

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