We are huge fans of utilizing fixed-income investments to build the base of an income portfolio. Fixed-income includes preferred shares, bonds/baby bonds, and bond funds.
The concept of fixed-income is a little bit different than you might be used to if you have only been investing in common stocks. A fixed-income investment is one that has a set principal that is owed to the investor, and until that principal is paid back, the investor gets a coupon payment.
While capital gains are definitely possible in fixed-income investments, the primary goal of these investments is to provide steady and stable income.
Preferred equity is one of our favorite forms of fixed-income because they are easily accessible to retail investors. They trade just like common shares do, with different tickers.
Preferred equity is one step up the ladder in the company's capital structure. Technically, preferred shares are "equity", which means that the coupon payments are dividends, not interest. This can have some tax advantages as preferred share dividends can be "qualified" or be "199a" income allowing you to take advantage of lower taxes.
Preferred equity will pay out a predetermined level of dividends. Companies do have the right to suspend these dividends, however they cannot pay a single penny to the common shares until they are current on their dividend payments to the preferred. Additionally, many preferred shares are "cumulative", meaning that if the company suspends the dividends they will continue to accrue and they must pay all missed dividends before they can resume preferred dividends.
This feature is particularly useful for REITs, which are required to distribute a majority of their taxable income to equity holders. While they can suspend dividends when they have no taxable income, as soon as the REIT has taxable income, the preferred shareholders are first in line to get paid.
Most of preferred investments will have a "par" value, which is the amount the company owes to the investor to redeem the shares. The most common is $25, although it can be any amount the company wishes to assign. There will be a "call date" which is the date where the company has the right, but not the obligation, to redeem the shares. When the company calls the shares, they will have to pay the par value (usually $25), plus any accrued and unpaid dividends.
As equity, preferred shares will fall in price when the entire market is falling. For example, many fell to very low prices in March 2020. However, most recovered relatively quickly compared to the common equity for the same company. Making those sell-offs an excellent opportunity to lock in high-yields. In normal times, preferred shares will trade with relative stability, being highly influenced by their call date and anchored to their par value.
Since preferred shares are below debt in the capital structure, they usually have higher yields than debt. However, since they are above the common equity, the dividends are less likely to be suspended, the amount cannot be changed and if suspended the dividends will be caught back up when the company resumes paying dividends.
For an income portfolio, this is a great combination of higher-yields and the confidence that our income will keep coming in.
Our model portfolio generally carries over 50 preferred stocks at any given time. During times of market turmoil, they are frequently our top buying targets as their prices tend to recover quickly.