Time To Buy The Bottom In These Yields?

As contrarian income seekers we buy when yields are high and prices are low. Today, we’re going to explore a three-pack of dividend funds that pays 8.5%.

This is “retire in style” income. We put a million dollars in these plays and get paid $85,000 per year. Plus, we keep our principal intact.

And wait, there’s more. The cheapest of these three funds is currently trading for just 89 cents on the dollar. Yes, that’s an 11% discount to the value of its underlying holdings.

Too good to be true? Or bottom-fishing bargain? Let’s explore my preferred dividend strategy and these three dividend machines.

The high-yield haven in question is called “preferred stock”—a lesser-seen type of stock that some companies will issue when they want to raise money but, for whatever reason, don’t want to issue more traditional stock nor bonds.

Which is interesting, because preferreds share characteristics of both.

On the one hand, preferreds trade on an exchange and represent equity in the issuing company, just like common stock.

But rather than trading violently up and down, preferreds usually trade around a par value, deliver a fixed amount of income, and typically don’t include voting rights, just like bonds.

But what I love about preferreds are their unique perks:

• “Preference”: The term “preferred stock” comes from the fact that the shares have “preference” over common stock. That means preferred dividends actually must be paid out before dividends on common stocks. Most of this time, it doesn’t matter, but it can act as a little extra protection from having your dividends cut or suspended when the company is struggling.
• Cumulative dividends: Sometimes—not always, but sometimes—they can pay “cumulative” dividends. That means that if a company misses even a single dividend payment to preferred shareholders, it must make up that payment before it pays any dividends on common stock again.
• Giant yields. Much more often than not, preferred-stock dividends will be far higher than their respective common stock.

For instance, Citigroup (NYSE:C) yields a decently high 4.5%, but its Series J Preferreds yield well more than that, at 6.9%. More striking is conglomerate Danaher (NYSE:DHR), whose commons yield a paltry 0.4% while its Series B Preferreds dole out a respectable 3.6%.

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So, if preferreds are so great, why are they eating asphalt?

Because preferreds are so bond-like—namely, their returns are all about yields—they historically have been a lot more stable than common stock. But that very same characteristic has allowed them to fall victim to an aggressive Federal Reserve, with persistent rate hikes sending bonds and preferreds alike to the mat.

But eventually, rates will top out. We are heading into the most telegraphed recession in American history. As the economy slows down, money will come back to the bond market.

And preferred-stock closed-end funds (CEFs) in particular will soar. They trade like bonds but better—when the rate winds are at our backs, these CEFs can really soar.

Today the three we are going to discuss all yield 8% or more. All three are trading for well below their net asset value (NAV), which means we’re buying these big dividends for as little as 89 cents on the dollar.

• Distribution Yield: 8.4%

We’ll start with one of the freshest-faced CEFs on the market: The Nuveen Variable Rate Preferred & Income Fund (NYSE:NPFD), which came to life less than a year ago on Dec. 15, 2021.

Thus, the 9.3% discount as I write vs. its “historical” discount of 8.2% doesn’t mean as much—but it’s still a nearly 10% discount on preferred assets and an 8%-plus yield, so it’s worth exploring.

NPFD primarily invests in companies’ variable-rate preferred securities (and other variable-rate income-producing securities). As should be no surprise, those companies are predominantly financial-sector firms: the top four industries by exposure are diversified banks (28%), insurance (14%), regional banks (14%) and capital markets (12%). No. 5, for contrast, is oil, gas and consumable fuels at a steep dropoff of 5%.

Credit quality is quite high, too, with more than two-thirds of the fund’s assets allocated to investment-grade preferreds; another 27% are in the highest junk level (BB), leaving only about 4% in B- and unrated securities. But despite this high quality, NPFD manages a juicy yield of more than 8% by going all-in on leverage—38% as of the most recent data.

So, why variable-rate preferreds?

Well, much like floating-rate loans help reduce readers, several CEFs (including preferred funds) are being hampered by higher borrowing costs thanks to rising short-term rates.