A Top-Line Analysis of Income-Generating Investment Strategies
When investors navigate the complexities of evaluating income-producing portfolio strategies, a critical decision emerges: whether to invest in general common stocks with dividends, REIT stocks with dividends, preferred stocks, corporate bonds, and treasury bonds. This document aims to address each of these options, incorporating insights on the structure of the assets, risk, liquidation preference, growth limits, voting rights, and possible tax efficiencies.
We broke out this analysis into sections to walk through each pairing so as not to get overwhelmed by the comparisons.
Preferred Stock vs. Common Stock Dividends: Starting with the most commonly discussed pairing of preferred stock shares vs. general common stock shares that pay dividends. While everyone knows common stock shares that you buy and sell on the exchanges are pure equity purchases that rise and fall with the whims of the market. For this comparison, we are focusing on only those common shares that pay common dividends to keep it comparable for the topic at hand; which is income-producing assets.
Since preferred securities are higher in seniority than common equities, dividends must be paid to preferred shareholders before common shareholders.
I. Priority in Dividend Payments: Preferred stock dividends receive preferential treatment over common stock dividends, entitling preferred stockholders to dividends before their common counterparts. This prioritization ensures a more stable income stream for preferred stockholders, particularly during economic uncertainty, offering a sense of security and reliability.
II. Fixed Dividend Payments: Preferred stock dividends are typically fixed, providing a predictable and steady income for investors. In contrast, common stock dividends fluctuate based on company earnings and board decisions, making them less reliable for income-focused investors. The fixed nature of preferred stock dividends is especially appealing to risk-averse investors seeking stability.
III. Convertibility and Call Features: Preferred stocks occasionally offer additional features like convertibility into common stock or call options, providing flexibility and potential for capital appreciation. These features enhance the appeal of preferred stock dividends. Evoking this strategy has been a long-time favorite of Warren Buffett. His trades have been well-documented, such as when he bailed out Bank of America back in August of 2011 with a $5 billion investment of preferred shares. The shares paid a 6% annual dividend and were convertible to common shares at $7.14 each. The Oracle of Omaha exercised his right to convert those preferred shares to 700 million common shares in June 2017, making an instant profit of $11.7 billion on top of the annual dividends collected since 2011.
IV. Tax Efficiency: In some jurisdictions, preferred stock dividends may be taxed at a more favorable rate than interest income from corporate bonds, adding to the after-tax returns for preferred stockholders. This tax advantage further strengthens the case for preferred stock dividends in income-oriented investment strategies.
V. Sector Concentration: Common stock shares that pay out dividends happen in all sectors of the market across any dividend-paying stock and long-standing “Kings” and “Aristocrat” dividend payers such as KO, IBM, BMY, CMCSA, MMM, etc.
VI. Limited Exposure to Market Volatility:
Preferred stock dividends exhibit greater stability during market fluctuations compared to common stock dividends. The value of preferred stocks is influenced more by interest rates and credit quality than by changes in the company's performance. This stability makes preferred stock dividends attractive to investors looking to minimize exposure to broader market volatility. Effectively, preferred shares have the effect of acting much more like fixed-income bonds than common stock. You know what your dividend yield will be when you buy preferred shares, and typically you don’t quite participate in the upside as much as common shareholders.
While common stock and preferred stock both have their merits, preferred stock dividends often stand out as a more attractive option for certain investors. The priority in dividend payments, fixed nature of dividends, limited exposure to market volatility, and additional features make preferred stock dividends a compelling choice for income-focused and risk-averse investors.
Preferred Stocks vs. Bonds:
This brings us to the next breakdown of income-producing assets and comparing Preferred shares to bonds. While preferred shares are often more akin to bonds than to common stock, as it turns out, there are a few differences between the two.
I. Equity Ownership and Potential for Capital Appreciation:
Going back to our example of Warren Buffett's success, preferred stocks, offering partial ownership of the company, provide investors with the potential for capital appreciation, a feature absent in corporate bonds. This equity ownership adds an extra layer of potential return beyond fixed income, making preferred stocks an attractive option for wealth accumulation.
II. Higher Yields and Enhanced Income:
Preferred stocks typically offer higher yields than corporate bonds or government bonds, contributing to a more attractive income stream. Often, preferred shares offer dividend payouts of roughly 6-8% on average. Treasury yields are historically 3-5%, and with the current market conditions, they are in the upper area closer to 5%, with the 10-year at 4.65% at the time of this article.
Corporate bonds can range much more based on risk factors, with Junk status typically offering the highest yield given the risk, compared to the Aaa typically being the lowest. However, the range is usually around 5% - 6.5% on average.
So again, while government bonds are traditionally considered the “safest” investment, corporate bonds are typically considered the next safest; preferred stocks present a compelling alternative with unique advantages. The potential for higher returns, enhanced income through higher yields, potential for dividend growth, and additional features like convertibility contribute to the attractiveness of preferred stocks.
While bonds offer investors stability of payments and a greater liquidation hierarchy, investors generally look to preferred securities for their higher-yielding, stable dividend payments.
Preferred Stocks vs. REITs:
Finally, one of the strongest income-producing asset classes on the market today is REITs. It is true that owning a piece of commercial real estate does offer a very different correlation to the general stock market and allows the average investor to own a piece of an asset class they otherwise would never be able to afford. Additionally, there is a lot of talk about how great an investment real estate is over the long-term, and while that is true, in this current market of rising interest rates, commercial real estate has definitely shown its cracks.
The commercial real estate markets have been in turmoil since June of 2022 when everyone started to really take note of the rising interest rates, and the transaction markets completely froze. Fast forward almost a year and a half, and transactions remain massively subdued from their 2021 levels, but also from their more steady state trends prior to COVID.
The rise in interest rates is putting heavy pressure on the variable rate debt MANY highly leveraged commercial assets were purchased with, which has caused many to pause in investing in the assets. Additionally, the true valuations of properties are being reset in the minds of both buyers and sellers, causing more turmoil and hesitation on anyone’s part to jump back into the markets as either a buyer or seller.
The best thing for REITs is that typically their leverage is far less risky than private real estate companies, capping at 65% and on average typically hovers around 55% depending on the sector. This definitely helps them weather these types of storms far better, along with many of them typically holding fixed-rate notes so the risk of their defaults is far less than the usually more aggressive private real estate.
That being said, when comparing REIT dividend-paying stock to preferred shares, there still remains some interesting observations.
I. Stability and Priority in Dividend Payments: Preferred stock dividends are deemed superior to REITs due to the stability and priority in dividend payments. The higher claim on company assets ensures a more stable income stream for preferred stockholders, offering dependability and predictability.
II. Fixed Dividend Payments: The fixed nature of preferred stock dividends contrasts with the variable nature of REIT dividends, which are influenced by real estate market performance. The predictability of preferred stock dividends makes them more attractive to risk-averse investors prioritizing income stability.
III. Higher Yields and Enhanced Income: Preferred stocks typically offer higher yields than REIT dividend stocks, contributing to a more attractive income stream. As discussed previously with bonds, preferred shares offer dividend payouts of roughly 6-8% on average. REIT stocks historically offer 3-5%. Currently, they are closer to averaging more towards the upper end of that spectrum due to the stock prices decreasing on those stocks.
While the price decreases are helping to support higher dividend yields in the short-term, those same decreases also put additional pressure on the safety of those dividends. Great examples are looking at mortgage REITs such as NLY, returning a dividend yield north of 15% at the time of this publication. However, they have a Net Debt to EBITDA ratio of 5.4 (risky is anything above 4.0), and a Dividend payout ratio of 88% (risky is anything at 60% or higher) and a dividend coverage ratio of only 1.13, which is closer to the ideal 1.25. In their favor, they do have a healthy Free Cash Flow to Equity of 2.72 (north of 1.25 is considered good). However, that is inflated because they have been borrowing so much cash over the TTM, which is why their Net Debt to EBITDA is so bad…
While both preferred stocks and REITs offer income-generating opportunities, preferred stock dividends are often considered superior for income-focused investors. The stability, fixed nature, and limited exposure to real estate market volatility contribute to the attractiveness of preferred stocks.
Correlations:
In addition to higher yields, preferred stocks have low correlations with other asset classes such as common stocks and bonds, thus providing potential portfolio diversification and risk-reduction benefits. The graph below compares the 10-year correlation of preferred securities, as represented by the S&P U.S Preferred Stock Index, to other asset classes. It is important to note that preferred securities exhibit higher correlation with high-yield bonds and equities, which are more sensitive to credit, and lower correlation with municipal bonds, which are more sensitive to interest rate risk.
Conclusion:
In the realm of income-generating investment strategies, preferred stocks emerge as a compelling choice for various reasons. The priority in dividend payments, fixed nature of dividends, limited exposure to market volatility, additional features like convertibility, and potential tax efficiency make preferred stock dividends stand out. Whether compared to common stock dividends, corporate bonds, government bonds, or REITs, preferred stocks exhibit unique advantages that cater to the needs of income-focused investors. However, it is crucial for investors to align their choice with their specific financial goals, risk tolerance, and investment strategy. The dynamic and versatile nature of preferred stocks positions them as a prudent option for those seeking a balanced and reliable approach to wealth creation.
GENERAL DISCLAIMER
All information provided is impersonal and not tailored to the needs of any person, entity, or group of persons. Past performance of an index is not a guarantee of future results.
It is not possible to invest directly in an index. Exposure to an asset class represented by an index is available through investable instruments based on that index. Gap Shares, LLC is not an investment advisor and makes no representation regarding the advisability of investing in any such investment fund or other investment vehicle. A decision to invest in any such investment fund or other investment vehicle should not be made in reliance on any of the statements set forth in this document. Prospective investors are advised to make an investment in any such fund or other vehicle only after carefully considering the risks associated with investing in such funds, as detailed in an offering memorandum or similar document that is prepared by or on behalf of the issuer of the investment fund or other vehicle.
Inclusion of a security within an index is not a recommendation by Gap Shares, LLC to buy, sell, or hold such security, nor is it considered to be investment advice.
These materials have been prepared solely for informational purposes based upon information generally available to the public and from sources believed to be reliable.
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