While the press talks about the inverted yield curve (again!) and scares everyone with talk of the recession, we dividend investors (and especially closed-end funds!) need to talk about strategy.
I’ll drop a ticker perfectly suited to these weird times in a second. First, let’s look at what the inverted yield curve is, because it actually creates a nice buying opportunity for us.
The “yield” in the “yield curve” refers to the yields of 10-year and 2-year Treasury bills. Normally, the 10 year yields more than the 2 year, but in recent days, this gap has narrowed to almost nothing.
When the two flip, we get the inverted yield curve that everyone is worried about. And to be fair, there East good reason to worry about a reversal, as we’ve preceded every recession since 1956. As you can see above, the last reversal happened at the end of 2019, just before the crash of 2020.
Of course, the last recession was caused by a pandemic that only happens once in a century, so it’s hard to say that the inverted yield curve really predicted this market drop. But during a previous reversal in 2006, there were more signs of an impending downturn: house prices were reaching unsustainable levels, borrowing costs were rising, and many Americans were over-leveraged. We can see some echoes of that time today.
Fortunately, we have not yet reached an inverted yield curve, and we may not; after all, the yield gap we see today is close to that of 1994, although back then a recession would not occur for seven years. And investors who panicked at that time would have missed out on massive gains.
Investors who went cash when this yield curve tightened and nearly inverted would have missed a 205% gain over the next few years waiting out the recession.
This brings us to another key point about the yield curve: even when it inverts, there is still a lag between the inversion and the onset of recession. In the 2006 example mentioned above, the reversal preceded the start of the recession by 16 months, for example, and the market peaked 14 months later, in October 2007.
In the 1994 and 2007 examples, being out of the market would have meant missing out on a considerable advantage, and anyone selling now faces the same risk.
This “Third Way” Dividend Payer Pays Us a Stable 7.8% Dividend
So what are we going to do? We will bolster our portfolios with an investment that does well when recession fears are on the rise: preferred stocks.
Preferred shares can be traded on an exchange, like common stock, but they trade around a par value and distribute a fixed regular payment, like a bond. A major advantage is that you get a higher dividend than “ordinary” shareholders. Today, the preferences expressed by JPMorgan Chase & Co. (JPM) yield of 4.75%, for example, well above the 2.8% paid by common stock.
And if you buy your favorite stocks through a CEF – which I recommend, because preferred stocks are difficult for individual investors to buy – you’ll increase your yield even further, to 7.8% in the case of the fund whose we’ll talk about below.
There’s another reason why preferred stocks perform well in times like these, and it comes down to the yield curve. Imagine that there is a range of assets in terms of risk, from the riskiest (stocks) to the least risky (treasuries). As volatility increases, money flows from the risky end to the less risky end of the spectrum, through our favorite “hybrid” stocks.
The Spectrum of Risks
Likewise, during that short window when things start to look up (like in mid-2020 when the Federal Reserve stepped in, economies partially reopened, and signs of an effective vaccine were emerging), investors will return to stocks. ordinary, hitting our favorites again along the way.
Our “Checkpoint” preferred stock game (for 7.8% dividend)
A fund like Flaherty & Crumrine Preferred Securities and Income Fund (FFC) is the ideal vehicle for obtaining gains and dividends when investors switch from equities to bonds and vice versa.
As mentioned, FFC yields 7.8%, which is another reason why it tends to do well when investors are worried, because that’s when they look for higher yielding stocks. raised. You can see this playing out during the pandemic crash, when the FFC beat the benchmark S&P 500 ETF and the iShares 20+ Year Treasury Bond ETF (TLT)which is a good indicator of long-term Treasuries.
As its name suggests, FFC holds a mix of preferred stocks, as well as bonds issued by banks and insurance companies, such as MetLife (MET), Citigroup (C) and Morgan Stanley (MS). (Financial companies are by far the largest issuers of preferred stock.)
Here’s another reason why FFC might make sense for your portfolio now: it’s trading at a 0.58% premium to net asset value (NAV, or the value of its holdings).
I know it doesn’t sound that big a deal (who wants to pay more than their holdings are worth?), but this fund typically trades at a higher premium: over the past five years, its premium has averaged 2 .9%, and as recently as last November, FFC’s premium was north of 6%. This means we have an additional upside opportunity as the fund’s premium returns to more normal levels.
Michael Foster is the Principal Research Analyst for Opposite perspectives. For more revenue ideas, click here for our latest report »Indestructible income: 5 advantageous funds with safe dividends of 7.5%.”