Co-produced with PendragonY
Preferred stocks are often misunderstood. Some liken them to bonds and evaluate them using metrics developed for bonds. Others, particularly dividend growth investors, see them as pale imitations of dividend-paying common stocks. The truth is that preferred shares fall in between bonds and dividend-paying common stocks. They pay dividends and not interest (which is important for tax considerations). But the amount of dividends paid is locked in by provisions in the prospectus. While most pay a fixed rate, some do pay a rate that can change over time. In such as case, the amount of the dividend paid might change, but this amount is still determined by provisions in the prospectus. So there is very little guessing on what the Board of Directors will do. This is unlike dividends from common shares.
When investing in preferred shares rather than in dividend-paying common shares, you make a trade-off. You give up the possibility that the dividend will increase as the fortunes of the company improve, for a greater likelihood of being paid. This increased safety of the payment is the result of preferred share dividends being required to be paid in full before the common shares get any dividend. Some preferred also pay a cumulative dividend. What this means is that if any preferred dividend is missed, the common shares won’t get a dividend payment until all the missed dividends for the preferred shares have been paid.
There are a lot of different ways to approach dividend growth investing. The traditional path focuses on lower-yielding stocks that aggressively grow the dividend each year. This produces a growing dividend for the whole portfolio that is a product of both the new shares bought with reinvested dividends and the increased dividend per share.
Another way to grow your dividend payout places its focus differently. It focuses on stocks that pay a very generous dividend (much higher than those of dividend growth stocks) while putting much less emphasis on how fast the company grows that dividend. This will produce income growth paid by the whole portfolio because it allows you to use part of the big dividends you receive to buy more new shares. For investors who have smaller portfolios or less time to retirement, this income method can be a better choice.
This higher assurance of collecting the dividend can also allow you to take much less risk and collect higher dividends.
Even better, if one invests in companies that have legal requirements to pay dividends, your dividends are even safer. For example, BDCs (Business Development Companies) and REITs (Real Estate Investment Trusts) must by law distributed 90% of their taxable income as dividends. Typically, the preferred shares’ dividend payment is far smaller than the total dividend payment required to meet this obligation. In order to meet this legal obligation, the company will have to pay the common shares a dividend as well. Since the company has to pay the entire dividend on the preferred shares before they can pay any dividend to common shareholders, this makes the dividend on the preferred even safer than it is for a regular company.
Example #1: A Company that Got in Trouble
Because both REITs and BDCs have legal requirements to distribute taxable income as dividends, their preferred shares tend to be safer than those of regular C-Corps. Even in bad times, the company will often not suspend the dividend in the preferred shares. A fairly infamous example of this the company now known as Vereit (VER). Back in late 2014 and 2015, when it was known as American Realty Capital, what first appeared to be a minor accounting error came to light. When all the details came out, it turned out to be a case of fraud. And that brought down the whole management team and the Board of Directors. The new management team had so little trust in prior management that they actually sent people to all the listed properties to verify them in person. The common dividend was eliminated for a time, and when restored it was both much smaller and was paid on a quarterly cycle (when before ARCP had a monthly payment schedule). The scandal was so bad the company even changed its name.
In the chart below, we can see a comparison between the total return of the common shares versus the preferred shares of Vereit.
Source: SA Performance Page
VEREIT, Inc., 6.70% Series F Cumulative Redeemable Preferred Stock (VER.PF) is a preferred issue from Vereit. Notice the big hit the common take around the time of the accounting scandal and how long they take to begin producing a return again. Notice that the accounting scandal barely impacted the preferred shares and that they consistently produced a return well above the common shares.
Also in the chart above, notice too that the common shares took a bigger hit from COVID and took longer to recover.
Because VER-F is a cumulative preferred and comparatively small, VER despite all its troubles never suspended the dividend as seen in the chart below.
Source: VER-F dividend history
Buying the common shares of VER was a risky gamble after the accounting scandal broke, and one that has still to pay off. However, the VER-F preferred issue had lower risks and has paid off quite nicely.
Example #2: A Company with Cyclical Earnings
Exantas Capital (XAN) and its preferred issue Exantas Capital Corp. 8.625% Cumulative Preferred C (XAN.PC) provide yet another example of how investing in the preferred shares of a REIT (in this case a mortgage REIT), can produce better returns and less risk than the common shares. Mortgage REITs have cyclical earnings, and thus dividends do vary (up or down) depending on the cycle. That can work to your advantage if you know the cycle and can enter and exit the stock at good times. But that is a lot of work.
With the preferred shares, you can just keep collecting the dividends with very few worries. Just like the VEREIT preferred stated above, XAN-C has the benefit of cumulative dividend payments.
The company had a much bigger cash flow issue that they had to suspend the dividends on the preferred shares too, but they were soon restored. So although the common shares have received no dividend payments this year, the preferred shares dividend that was suspended were fully repaid in September. Investors got a payment equal to 3 quarterly dividends in September.
Source: SA Performance Page
We can see from the chart above, that XAN-C has outperformed XAN since early 2016, which is very nice considering the lower risk. But look at what happened with the COVID crash and the dividend suspension. Based on what management said in the latest conference call, the common dividend is unlikely to be resumed until the next fiscal year. Meanwhile, the dividend on the preferred shares has not only been resumed, but all the unpaid payments have been caught up. The cumulative nature of the dividends resulted in no loss of dividends to preferred shareholders.
The chart below doesn’t do a good job of showing the period where the dividend was suspended, but it does show the 3 times dividend payment in September.
Source: SA Dividend History Page
Example #3: A Good Pick Today
We recently highlighted a preferred stock issued by Cherry Hill Mortgage Investment Corporation (CHMI). The preferred issue is Cherry Hill Mortgage Investment Corporation 8.20% Cumulative Series A Preferred (CHMI.PA). Since we wrote that article, Cherry Hill released their Q3 earnings result, including a big drop in book value that was largely due to a recalculation of the value of its tax-deferred assets. Correctly valuing such assets is a complicated process and they are often re-evaluated after some assets are sold. That appears to be what has happened here. As of this writing, there is no indication of any wrongdoing. But accounting errors always make investors nervous. Prudent investors may sell CHMI now rather than confirming this was just an honest error. But this also shows why buying the preferred shares can be less risky. They are in no danger, as assets more than cover the preferred if things go wrong. This error will also have no impact on the ability of the company to pay their preferred dividends, even if the error turned out to be twice or three times larger than initially estimated. This is because the company can eliminate the common stock dividends to pay its preferred share dividends.
The preferred stock CHMI-A is a relatively new preferred stock issued by the company. But as we can see in the chart below, even in just the 3 years since it was issued, it has already begun to produce bigger returns than the common.
Source: SA Performance Page
We can also note in the chart above that the preferred has fully recovered from the COVID crash, while the common still lags.
The first dividend paid by CHMI-A was lower than all the others, because on the date for payment of the first dividend the shares had not yet been available for a full quarter. Since then we have gotten regular, reliable payments.
Source: CHMI-A Dividend History
Those payments are the core reason for the solid returns.
There is much confusion over preferred shares because they fall in-between bonds and dividend-paying stocks. But, because of the extra safety and reliability they offer, they can play an important role in an income-oriented portfolio. Investing in companies that have requirements to distribute dividends can make them even safer. REITs are one such type of company. mREITS – REITs that invest in mortgages – often have very cyclical profits which means their dividends are cyclical as well. Preferred shares from mREITs are a way to invest in them while getting a steady payout. We have shown 3 such investments, VER-F, XAN-C, and CHMI-A where such steady dividends allowed the preferreds to have better returns than an investment in the common shares of each company.
In today’s yieldless world, preferred stocks can significantly boost your income while taking a relatively low risk. The preferred stock portfolio currently recommended to our investment community has over 50 preferred stocks with an average yield of +7%. This sure beats the 10-year and 30-year treasury yields which respectively yield 0.8% and 1.6%. In fact, with inflation adjusted, investing in Treasuries will provide you with a negative yield. Because preferred shares are misunderstood, they are underused by income investors.
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Disclosure: I am/we are long XAN.PC, CHMI-A, AND VER.PF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Treading Softly, Beyond Saving, PendragonY, and Preferred Stock Trader all are supporting contributors for High Dividend Opportunities.