Generating Income - an Alternative Idea

August 29, 2013

Prepare to be underwhelmed! With interest rates having risen substantially over the past few months, I wondered to myself if banks had similarly begun increasing the rates they are offering on CDs to customers. The answer can be found in a brief listing of CD's, culled from a search this morning:

Unfortunately, the bank is lending your money out and receiving a much greater rate of interest on your money than is being paid out to you. How does one generate a better return on their cash? Bonds are a great way to do it - but there is another option to consider that isn't as well known or popular, but is worth considering: preferred stock.

Preferred stock operates similar to a hybrid car that can run on both gasoline and battery power. Like common stock, they exchange hands daily on trading exchanges and can be bought and sold easily. Like bonds, you own preferred stock for the income as opposed to price appreciation. At the moment, many preferred shares are paying annual interest of just over 6% - an attractive number for any income investor.

With any fixed income security, be it bonds or preferred stock, there are two risks to consider. The first is default, the risk of a company falling into bankruptcy and being unable to meet its debt obligations. Though the risk of default is never zero, through careful selection and individual analysis, this risk can be greatly mitigated. The other is interest rate risk, which has manifested itself greatly over the past few months. Rising interest rates cause the price of bonds to fall and preferred shares have been impacted as well, as prices have dropped recently.

So, how do you deal with interest rate risk? Many preferred shares have long-term maturities or are perpetual (no maturity date), which makes them more sensitive to rises in interest rates. Our solution is to look for shares that we believe have a greater likelihood of being redeemed in the near future (many shares have call provisions which means they can be redeemed early by the issuer). Each share has a specific redemption price known as its "par value," which is usually $25 per share. With many shares currently trading at discounts to par ($22-$24 per share), a redemption at $25 per share has the potential to offer an attractive capital gain as well.

It's important to know that there is no guarantee that shares will be redeemed in the near future, or if ever. However, with rates remaining well below 6%, it's not a stretch to think that many large banks and insurance companies will look to refinance these shares at the earliest opportunity, no sooner than you would with a 6% mortgage that could be refinanced to 4%.

Chuck Wade

(This article contains the current opinions of the author but not necessarily those of Brighton Securities Corp. The author's opinions are subject to change without notice. This blog post is for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities).