This retirement investment generates steady income without dramatic risk

One of the most challenging aspects of managing money in the past few years has been extraordinarily low yields from government bonds — bordering on zero and even negative when you consider inflation.

Given that bonds make up a large percentage of traditional retirement investor portfolios, that lack of that steady income hurts.

More than four years ago, this problem surfaced.

“There are no easy answers. The dilemma is particularly acute for retirees,” Burt Malkiel, economist and a member of my firm’s investment committee, wrote at the time in The Wall Street Journal. “A generation ago they could invest their savings in a 10-year U.S. government bond and be able to count on a promised interest rate of 6% to 7%. They could also sleep well at night knowing that their portfolios consisted of one of the safest assets in the world.”

Retirees typically have broad income diversification, beyond government debt, through high-yield debt, emerging market bonds, investment-grade corporate bonds and inflation-protected government bonds (TIPS). In the hunt for more return without dramatically increased risk we took a hard look at preferred stock.

A lot of retirement investors (and many investment advisers) find preferred stock mystifying. That’s because it seems to be two things at once: a bond and a stock.

Preferred stock is a hybrid security that pays a fixed dividend like a bond but also represents ownership in a company, like a stock. While technically a stock investment, preferred issuances actually function somewhere between bonds and stocks.

For instance, like corporate bonds, preferreds are tracked by major credit rating firms. Preferreds are investment grade, but often they are rated lower than bonds because preferreds are junior to the bonds of the same company.

Being “junior” means that, in a bankruptcy, bond investors are repaid ahead of preferred stock investors. However, preferred stock investors are in turn repaid ahead of common stockholders.

On the plus side, preferred stock prudently generates higher returns while lowering risk. Ultimately, that means more money in retirement.

Besides superior yields, preferreds tend to be less volatile than common stocks. In addition, while bond interest is taxable at personal income-tax rates, preferred stock dividends are taxed at more attractive long-term capital-gains rates.

So what are the potential downsides? Preferred stocks are stocks. They are by definition riskier than bonds.

Secondly, as interest rates rise the valuation of preferred stocks can fall, as would bonds. Nevertheless, rising interest rates due to economic growth tend to increase the creditworthiness of preferreds, especially those issued by commercial banks, which benefit from higher rates.

As long as interest from high-quality debt such as U.S. government bonds remains depressed, it’s reasonable to seek better returns at an acceptable level of risk among your income-oriented investments.

High-quality preferred stocks with attractive dividend streams are relatively stable and only moderately more volatile than bonds. This means that preferred stocks could be a useful part of an investor’s portfolio in an environment starved for income.

Most preferred stock is offered by large financial institutions, among them the largest U.S. banks and insurance companies. We recommend the iShares Preferred and Income Securities ETF (PFF) for client portfolios The fund’s primary holdings include large bank issuers such as Wells Fargo, Citigroup, GMAC Capital, and JP Morgan.

The current SEC 30-day yield of that fund is 4.51%

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