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A Preferred Path in a Confounding Stock Market

December 19, 2018

One of the best ways to make a portfolio work through bullish and bearish markets is to ensure that you have a steady flow of reliable dividend income. This is especially the case when the general stock market has been nothing but a rolling coaster ride, as we’ve seen this year.

This is where preferred stocks come in handy. Preferred stocks offer typically higher dividends than ordinary common stocks. And they also tend to be locked in, providing security for investors as their dividends are fixed or linked to specific conditions.

They also provide more credit security than common stocks if and when trouble strikes. If a company runs into a crunch, preferred stockholders are paid before any common stockholder and just behind bond holders in a workout.

Preferred stocks were introduced back in the early 19th century, when American railroad companies were trying to expand their network of rail to reach western markets. There was intense competition to capture these new routes and the potential markets that awaited beyond the Mississippi.

Having tapped bond markets so heavily to fund their construction and operations of their eastern lines, they were limited in how much more debt the banks and other traditional funding methods were willing to issue them for such risky ventures.

The result was the innovation of preferred stock.

Basically, it gave investors a piece of both stocks and bonds in one investment vehicle.

Investors unwilling to take more bond risk were willing to take an equity stake that came with a fixed dividend.

The upside for these investors was if the expanded rails paid off, that there would be some participation in the profits. And if trouble occurred, then they would have the security of being in front of common stockholders. You see, bond holders are the first in line if a company goes under and has to repay its investors. Common shareholders are last in line.

Preferreds put shareholders ahead of stockholders and just behind bondholders. This gave investors a sense of safety coupled with some upside growth potential.

Preferreds have thrived since. And they continue to provide companies with attractive capital costs and investors with reliable dividends and credit security.

And while growth stocks tend to steal all the headlines these days, the current general stock market conditions have allowed preferred stocks to perform very well.

Since the recent bottom in dividend and income stocks in February 2018, the market for preferreds has generated a positive total return of 5.1%, as measured by the S&P Preferred Stock Index.

There are plenty of solid individual preferred shares out there. But the best place to start with preferreds is to let a professional build a portfolio of preferreds for you.

That’s why I like using closed-end mutual funds. They trade like stocks but have a collection of corporate preferreds in them like a typical mutual fund. They give you the ease of buying and selling them like stocks but the diversification of a mutual fund.

And that diversification can be especially important when it comes to unique investments like preferred stocks. The managers are expert at analyzing these assets, and this is one sector where it really pays to have a pro picking shares for you.

One of my favorite closed-end investment funds focused on preferreds is the Flaherty & Crumrine Preferred Income Opportunity Fund (PFO).

This is a well-run closed-end investment fund from a company that focuses on preferred stock in the majority of its fund offerings.

It has a great long-term performance, with the average annual equivalent running at 18.60% over the past 10 years for an overall return of 451.04%.

But what also makes it even more appealing is that the Flaherty & Crumrine closed-end fund tends to trade at a discount to the actual preferred shares, currently at 3.73%. That means that we can buy this great collection of preferreds in the fund at a discount to what they are worth in the market.

That makes for a bargain buy right now in an attractive market for preferred stocks.

And then there’s the dividend, which yields 7.46% with monthly dividend payouts.

The closed-end fund’s holdings are primarily in the US market, with a few holdings in Europe and Australia. Those holdings are primarily in banks and financial companies, which make up the vast majority of the holdings. This sector helps to provide added credit worthiness as US banks continue to be watched over like hawks from regulators despite regulatory reforms. And while bank common stocks aren’t reflecting the positive fundamentals of regulatory reformation, normalized interest rates and the positive impact of a growing economy, the stability of their preferreds works well now and going forward.

In addition, it also has holdings in the improving power utility companies segment, along with some of the profitable pipeline toll-taker companies that have issued preferred stock.

Flaherty & Crumrine Preferred Income Opportunity Fund is a good choice for dividend income and growth over time. Ideally it should be bought and held in a tax-free account.