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A Contractually Obligated Dividend

6/20/2013 10:03:00 AM
By: Wyatt Investment Research
Referenced Stocks:JPS;PFF

Editor's Note: Today I invited my colleague and contributing editor Steve Mauzy to share once of his favorite investment ideas in this issue of Income & Prosperity. For those of you unfamiliar with Steve's work, he's a top income investing expert and analyst at my High Yield Wealth investment newsletter.

If you're willing to venture a little out of your traditional income investor "comfort zone," you can achieve something that sounds impossible.

You can lower your risk, diversify your income, AND still collect healthy yields of over 7% a year.

If that sounds good to you, consider preferred stocks - hybrid securities that have characteristics of both stocks and bonds. 

You might have heard of these investments before, and perhaps thought you need a fortune to invest in them - or that they're too complicated.

But neither of these concerns is true.

Preferred stocks are like common stocks in that they pay dividends, and their shares trade on the major stock exchanges.

Preferred stocks are like bonds in that they are issued with a dividend-coupon based on par value. What's more, dividends are contractual, just like interest on a bond, so you know your cash flow ahead of time.

And like bonds, most preferred stocks are followed by rating agencies like Moody's and Standard & Poor's.

In short, preferred stocks are safer than common stocks because they have a higher claim on the company's assets. And in some instances, they are nearly as safe as bonds.

Best of all, there are quality preferred stocks that yield 7% and above. Good luck finding a quality bond or CD with a similar yield.

I mentioned that preferred stocks pay dividends, which imparts a tax advantage compared to interest on bonds (except some municipal bonds). Qualified preferred-stock dividends are taxed at a maximum rate of 15%, while interest is taxed at your marginal income tax rate. 

To be sure, preferred stocks aren't perfect. Individual selection can be an issue for some investors, because preferred stocks have a few more moving parts compared to common stocks. 

For instance, the vast majority of preferred stocks have a call date, where the issuing company can redeem the preferred stock. A call date doesn't mean an issue will be called, it means it can be called. But if a preferred stock is trading above par value, normally $25 a share, you can suffer a capital loss if you pick an issue that's called.

For this reason, I think preferred-stock funds are the safest bet. Funds are diversified, which assures there's no income disruption should any one issue be called; diversification also reduces portfolio risk.

One year ago, I added Nuveen Quality Preferred Income Fund II ( JPS ) , a closed-end preferred-stock fund, to the High Yield Wealth portfolio. This fund has performed exactly as expected - providing high-yield income with low price volatility. In addition to the nice yield, this fund has also risen in price.

Therefore, Nuveen serves a vital function. It's a proper fixed-income investment before the Federal Reserve wrung income out of most traditional fixed-income sources.

To be sure, there are many preferred-fund options. I could have chosen a preferred-stock ETF, but as a closed-end fund, Nuveen offers a few advantages.

For one, Nuveen is activity managed, which means it's able to generate a reliable monthly dividend in equal increments, at $0.055 a month. This is an important consideration if you depend on your investments to cover living expenses.

Most ETFs , in contrast, pay a variable dividend, so investors aren't sure what they'll get each month. Keep in mind that my preferred investment is a fixed-income surrogate, so I need to be reasonably assured of a reliable income stream.

Yield is another advantage. The Nuveen fund yields 7.5% as I write, which is 170 basis points higher than the 5.8% yield provided by the popular ETF iShares S&P U.S. Preferred Stock Index Fund ( PFF ) .

Here again, active management instills an advantage. Because Nuveen is actively managed, it can employ leverage where an ETF can't.

Nuveen's uses a reasonable amount of leverage to boost income. By exploiting today's low interest rates, the manager is able to consistently generate a yield higher than the vast majority of ETFs and quality individual issues. Applying the same strategy to an individual preferred stock would be risky for most investors. 

So if you to need to fill a fixed-income void left by the Fed's unconscionable monetary policies, Nuveen Quality Preferred Income Fund II is an investment that can fill that void.