Many advisors recommend that income investors split their portfolios between bonds, preferred stock, and common stock. Yet, at different points in the credit cycle, each of these assets will underperform and endanger investors’ wealth.
Thus, savvy investors should vary the mix of assets, allowing the credit cycle to determine their allocations.
Corporate Bonds: These vehicles do badly in a recession, when companies suffer cash flow deficits and sometimes run into default. On the other side, low-grade bonds are an excellent buy when the economy is coming out of a deep recession and the Fed is pumping money into the system. While some will still default, the majority will provide both income and capital gains as the market reassesses their value.
Preferred Stocks: These assets perform badly in periods of inflation and also underperform in economic upswings, when they capture none of the upside potential.
Dividend Stocks: They’re vulnerable to a general stock market downturn and also to recessions, during which dividends are often cut. Additionally, dividend stocks have become vulnerable in this economic upswing because companies have bought back stock at record rates, which will make balance sheets vulnerable in the next downturn.
Dividend stocks do best a little later in the cycle, when corporate cash flows have improved and companies begin to increase their dividend payouts. Of course, there’s always a chance that managers will be tempted into large share repurchases rather than dividend increases. Such repurchases over-leverage the company, over-inflate its share price in the short term, and mostly reward the company executives who have stock options.
A Closer Look at Our Current Situation
It’s been more than six years since the bottom of the economic cycle. The Fed is close to raising interest rates, unemployment is close to its cyclical low, and leverage is high in a number of vulnerable areas both domestic and international.
Additionally, the U.S. stock market is still close to record levels and is very high by historic standards. However, this isn’t true of many international markets – the MSCI Emerging Market stock index, for example, is down 18% over the past five years. For perspective, the S&P 500 has gained 85% over that same period.
Thus, it’s likely that dividend stocks aren’t the best investment right now, on cyclical grounds. If we’re fairly near to the next downturn, then we’re probably also near to a major stock market decline in which much of the market’s recent gains will be reversed. Yesterday’s early morning gap-down and last week’s losses could be just the beginning.
Even more important, many dividends will be cut or even eliminated in the next recession. We’ve seen what happens in the energy MLP space – dividends that appeared perfectly solid are eliminated once it’s impossible to maintain them at lower levels of earning capacity.
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Similarly, the Fed’s ultra-loose monetary policies have led to excess leverage and promoted leveraged buyout takeovers that will get into severe trouble in the next downturn. Any tightening in credit conditions will bring a rush of defaults, making low quality bonds a poor investment.
Prime corporate bonds will do better but will also suffer from any interest rate hike, whether the cause is the Fed raising short term rates or a modest surge in inflation.
Where Should Income Investors Turn?
To me, the best investment based on today’s credit conditions looks to be preferred stocks.
Their yields are high enough that they won’t be badly affected by a modest rise in interest rates. Plus, since preferred stock dividends are paid before common stock dividends, they have an extra level of protection against downturns.
By buying preferred stocks now, income investors will be able to switch into junk bonds and then back into dividend stocks at the bottom of the cycle when defaults are rife and stocks are depressed.
I wrote a few months ago about the nine preferred stock ETFs. Since you’re trying to protect against an economic downturn, you want to avoid the riskier funds that invest in high-yield preferred stocks. That leaves two reasonable choices.
One is the largest indexed ETF, the iShares U.S. Preferred Stock ETF (PFF). This chunky, $13-billion fund attempts to match the return of the S&P US Preferred Stock index. PFF has a below average expense ratio of 0.47% and a yield of 6.1%.
The other is the only preferred ETF that attempts to pick stocks, the First Trust Preferred Securities and Income ETF (FPE). It yields 5.8% and has a slightly higher year-to-date return (4.2%) compared to PFF (3%) – but it also has a higher expense ratio of 0.85%.
Bottom line: Income investors have it tough in this market, but by using preferred stocks, they can improve their return in the likely storms ahead and wait for better opportunities.