Preferred Stocks to Consider for Scary Times

The stock market has been spooked lately with all the tariffs imposed on a global basis with a near consensus that growth throughout the world is slowing.

Some observers even believe that a recession may lay ahead later this year. While the trading of common stock doesn’t directly affect us holders of preferred stocks and baby bonds, there are times when conservative investors, who seek to preserve capital, will sell their holdings simply out of fear.

When this happens, we start to see prices fall, particularly in the more marginal quality issues. These marginal issues are those from ocean shipping companies, energy companies and many of the retail-oriented real estate investment trusts (REITs).

Even conservative income investors at times invest in preferred issues from marginal issuers to “juice” their returns a bit and they are quick to sell out of higher-yielding risky preferred stocks when danger is lurking. Fear and greed are powerful instincts when you are 65 or 70 years old and looking to maintain your lifestyle in your retirement years. Income investors kind of want it all — they want to preserve capital at all costs, while at the same time garnering the maximum return on their investment.

I want to focus on an area of the preferred stock arena that we invest in and that should be considered by very conservative investors. This area is that of Closed End Fund (CEF) preferred stocks. In particular, we want to review a new issue from the Gabelli Dividend & Income Trust (NYSE:GDV).

Closed end funds (CEFs) sell preferred stock and issue baby bonds to use as leverage for the fund. Obviously, the hope is that the cost of the leverage is less than the anticipated return they can earn for the fund.

The great part of these issuances is that the amount of leverage that can be used by issuing senior securities (this refers to any security that is senior to the common stock) is closely regulated.  CEFs must maintain an asset coverage ratio of at least 200%, and in some cases 300%, of the senior securities. This means that for every dollar outstanding of the senior security, the fund must have at least $2 in assets.

Because of the leverage ratio requirements, the senior securities issued by closed-end funds are almost always strongly investment grade. In particular, closed-end funds that invest in Level 1 securities are the most highly rated. Level 1 securities includes issues that trade on stock exchanges whereby the current value is directly observable.

Gabelli Dividend & Income Trust is a closed-end fund that invests primarily in common stocks, although they hold a few preferred stocks. The CEF has three preferred stock issues outstanding at the current time, but they have just come to market with a fourth issue.

The new issue is 2 million shares of a perpetual, cumulative preferred stock with a coupon of 5.375%. The issue will trade on the NYSE under the ticker of GDV-H once it moves from the OTC Grey market where it currently is trading under the ticker GDVVP.  It last traded at a price of $25.19.

Moody’s rates this issue Aa3, which is a strong investment grade, and the CEF will carry an asset coverage ratio of 404% after the issuance of the new shares. This means that for every dollar of senior securities outstanding, GDVVP will have $4 of primarily common stock assets available to the senior holders in the event of a liquidation. This is why the issue is strongly investment grade.

It should be noted that because the preferred shares are perpetual, meaning they may never be redeemed, holders will incur interest rate risk. This means that if interest rates rise, the value of the shares will decline and if interest rates fall, prices will rise. The holder should concentrate on the income stream provided and place less emphasis on the day-to-day or month-to-month movement of the share price.

I realize that a 5.375% coupon is not a high yield, but that is exactly the point. One must sacrifice some yield to have a strong investment-grade security. In the end, it is a question of whether one wants to sleep well at night, or whether one wants to toss and turn while sleeping to garner an extra 1%. I have learned that for me, a modest coupon that is very safe is preferred to one with a high yield with corresponding high risk, but every investor is different.

In summary, conservative investors should consider purchasing positions in preferred stocks issued by some closed-end funds for extreme safety.

Disclosure–we own shares in the new Gabelli Dividend & Income Trust preferred.

Tim McPartland

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Tim McPartland is a private investor with over 45 years of investing experience. His analysis, research and writing is devoted to the hunt for income producing securities of all types, but in particular specializing in preferred stocks, exchange traded debt and Master Limited Partnerships.

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