Arithmetic in deed - Preferred are Better than Bonds!
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