To Boost Your Portfolio's Yield, Consider Preferred Stock

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It’s no secret that income investors are in a bind. As a result of the slow recovery from the worst recession in decades, near-zero interest rates have caused yields to plunge. Bank products like certificates of deposit and savings account pay almost nothing in interest. On the other hand, many investors, particularly those in or nearing retirement, are understandably reluctant to put all their money into stocks just to chase yield.

Fortunately, a comfortable balance can be struck in the form of preferred stock. Investors have likely heard the merits of a balanced portfolio including bonds and stocks. However, there exists a separate entity that, especially now, can offer you the best of both worlds.

A convenient mix

Preferred stock is commonly known as a hybrid security that display characteristics of both debt and equity securities. Like bonds, preferred stock receives coupon payments ahead of equity holders. Like traditional equities, preferred securities hold a subordinate position to a company’s bonds. Bondholders are the very first to have claim on a company’s cash flows; consequently, preferred securities generally yield more than a company’s bonds.

John Hancock offers two exchange-traded funds (ETF’s) of preferred securities with yields that far exceed the approximately 2% dividend yield on the S&P 500. The John Hancock Preferred Income Fund (NYSE: HPI) and John Hancock Preferred Income Fund III (NYSE: HPS) offer yields of 7% and 7.4%, respectively.

Interest rate risk

Of course, it’s important to discuss the main risk with any fixed income security, which is its sensitivity to interest rates. Prices and yields are inversely related. As interest rates rise, fixed income products generally decline in price, so that their yields adjust accordingly to the higher rates.

However, it’s worth noting that this theoretical relationship between fixed income securities and interest rates doesn’t always hold true. For example, during the 2008 financial crisis, the Federal Reserve cut interest rates to historic lows in an attempt to resuscitate the economy. Theory states that this should have been a boon for preferred securities such as the two John Hancock funds. However, HPI and HPS both fell dramatically along with the decline in interest rates.

Both funds proceeded to recover strongly in the years since, in tandem with the markets, and now trade near the levels seen before the Great Recession. The actual trading pattern of each fund defied the traditional relationship between fixed income products and interest rates.

The real concern is: default risk

As a result, it’s reasonable to consider the real risk of preferred stock funds to be the health of their underlying issuers. Most preferred stock is issued by financial institutions, and both John Hancock funds derive more than half of their holdings from the financial sector.

The American financial system as a whole was in danger of collapse during the depths of the recent financial crisis, so it shouldn’t be a surprise that these funds’ holdings plummeted along with the broader capital markets. As a result, it seems that over the past several years, credit risk took precedence to interest rate risk.

Indeed, both funds had to cut their distributions in March 2009 as America’s financial institutions teetered on the brink of total collapse. That being said, each has raised its distribution since then and their payouts are nearly what they were pre-crisis. Now that the financial system has stabilized, the funds’ volatility has subsided.

The Foolish conclusion

Preferred stock offers investors a convenient blend of debt and equity characteristics. For investors who rely on income from their investments, preferred stock funds such as these provide dependable income with yields greater than both stocks and bonds in the current environment.

While investing always carries risk, it seems that the two John Hancock funds are well-managed. Outside of another full-blown financial crisis, each fund should continue to provide big yields to investors with an occasional distribution increase.

If you're sick of earning almost nothing from savings accounts and certificates of deposit but don't want to expose yourself to the same level of risk of the stock market, preferred stock funds such as these may prove to be a suitable alternative.

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Robert Ciura owns shares of John Hancock Preferred Fund III. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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