Man do I love dividend growth investing. Buying blue-chip companies, receiving dividends, reinvesting the income, and let the compounding effect happen over time. I love buying companies like Coca-Cola (KO), Pepsi (PEP), Walmart (WMT, and Target (TGT).
Even better is buying growth companies that pay small dividends like Costco (COST) and Microsoft (MFST). Their small dividend yields (0.7%) will grow over the years. All I have to do is keep investing and reinvesting.
However, investing for income is completely different than dividend growth investing. Investing for income is all about getting paid—immediate income. I turn to my high-yield instruments for my income needs; instruments like REITs, Preferred Shares, Closed-End Funds, and Dividend ETFs.
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Today, I want to compare two of my favorite high-yield security types: Preferred Shares and Closed-End Funds. Both of these securities are all about finding ways to get the highest yields versus the current stock market. Let’s do a quick refresher about each type before we continue.
Preferred Shares. Preferred Shares are higher on the equity structure than common stock. Most preferred shares start with a value of $25 and trade on the open stock market, similar to common stocks. The company can buy back (or call) the stock after a certain timeframe, usually a few years.
When the company calls the stock, they pay shareholders the face value of the preferred shares. Thus the idea is to buy preferred shares at less than par value, hold them for the dividends, and then get par value upon redemption. Please read my series on preferred shares here.
Closed-End Funds. Closed-End Funds are mutual funds that have a set amount of outstanding shares. Open End mutual funds (normal) and ETFs adjust the number of shares as buyers buy and sell them on the open stock market.
Because closed-end funds have a fixed amount of shares, they can determine their Net Asset Value or NAV. The NAV is the value of all the investments inside of the closed-end fund. Based on the quality of the fund and managers, the fund can trade at a premium or discount to NAV.
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A good way to describe NAV is to compare it to new video game consoles. When the new Playstation 5 arrives, it has a Manufacturer’s Suggested Retail Price (MRSP) of $500. However, you will probably pay $700-800 on the open market due to shortages and increased demand.
Therefore, an investing strategy in CEFs is to buy when they are at a discount to NAV; that, way we can participate in higher yields and capital appreciation. Read my article on closed-end funds here.
Time to battle. Both types of securities can give us large amounts of income if we know what we are looking for when investing. Blindly buying either can lower yields and prevent us from maximizing capital gains. So, let’s start with how to research each of our security types.
Research. Closed-End Funds and Preferred Shares are more difficult to research than standard common stocks of companies like Procter & Gamble (PG) and AT&T (T).
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You will want to know if the CEF usually trades at a discount or premium to NAV for closed-end funds. You will want to look back since its inception. The good thing about CEFs is that a fund manager can control multiple funds. For example, PIMCO is my favorite fund manager. Since I trust PIMCO, I can buy into their various funds, leveraging my overall knowledge of their management expertise.
Preferred Shares are different because they come from a company. More than likely, you will not know the company. Sometimes, you find preferred shares from banks and REITs that you know, but the highest yields are from businesses you probably don’t know.
To research a preferred share, you have to look into the company. First, I like to see if they pay a dividend on the common stock; that is a good indicator. Next, I try to get an understanding of the company. This research can take longer than a CEF because CEF managers do all the research for you. You only need to trust the manager. Winner: CEFs.
Capital Gains. I do not invest in capital gains; however, we have a baseline to audit their value because of preferred shares’ par value and CEFs’ net asset value. By following the preferred and CEFs closely, we buy at deep discounts during market turmoil.
Preferreds have the upper hand in getting discounts. The hardest part of getting good deals in preferreds is finding the preferreds in the first place. Once you find them, either buy one share or add them to a watchlist. Then you can just wait until they go on sale.
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I bought preferred shares at $13 with a par value of $25. The yield at the time was 17%. The price has recovered to $25, and I am still yielding roughly 13% after buying more shares. You can find fantastic deals in the world of preferred shares.
CEFs can also sell at a discount, but usually when the entire market collapses. You will have to be ready. Late last year, I was able to buy PIMCO dynamic fund (PCI) at a nice discount to NAV. Winner: Preferred shares.
Income generation. Both securities produce excellent results; however, many CEFs pay monthly. As I mentioned in Living Overseas Passively 101, if I needed a certain amount to pay expenses abroad, I would have my CEFs pay me that income.
Remember, the company can call the preferred at any time after the call date. You don’t want to depend on this income and then have it taken from you randomly. Some CEFs offer the ability to set up dividend reinvestment. Some PIMCO funds provide a slight discount when you buy shares via dividend reinvestment. You can experience the effect of compounding with CEFs.
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Preferred shares are more like one-off investments. There is no guarantee you will be able to find similar preferreds once someone calls your investments. The best way to employ preferred shares is by purchasing them at steep discounts to par. As they get closer to their call date, they should naturally gravitate to par value.
CEFs allow you to make monthly contributions to your income pool. I can safely buy 15 shares of PCI monthly, for example. Preferred shares are not so accessible. You will need to research each month because prices can vary wildly.
Value. These securities extract value differently from each other. The value in closed-end funds is buying into high-yield vehicles safely. The value in preferred shares is finding diamonds in the rough at steep discounts.
With CEFs, you can find 2-3 CEFs that meet your needs and ride those until retirement. Once you have what you are looking for, there isn’t much need to keep searching. It is always nice to have a wishlist for market corrections, but you can just sit back and enjoy beyond that.
Preferred shares take more work to find those quality shares at steep discounts. However, you can find yields of 15-20% plus capital appreciation if the shares recover—this is how you unlock value in preferred shares.
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If I am looking towards retirement, CEFs hold the most value because of high, consistent dividend income. Preferred shares carry more weight when I am looking to maximize my revenue. For value, I have to give the advantage to CEFs.
Conclusion. There is a lot to like about both preferred shares and closed-end funds. Overall, I give the advantage to CEFs because you can buy them come rain or shine. Even when the market is near an all-time high, CEFs still hold value. Yes, you won’t get extreme yields, but safe, consistent income is always worth buying.
Investors are looking for yield with treasury bond rates at all-time lows and interest rates at zero. Would you rather pay $26 for a $25 preferred share or pay a 10% premium of your closed-end funds.
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With your preferred shares, you will lose money when the company calls them. Your CEFs give you the ability to dollar-cost-average your cost basis down over time. As an income investor, I know PIMCO and other managers. I trust the work they do, and they perform portfolio changes dynamically.
With preferred shares, I have to depend on that one company for my income. If I had $1,000, I would instead invest it into CEFs than preferreds, if I am completely honest. However, you can form your thesis over time.
I love both my CEF portfolio and my Preferred Shares portfolio. I love my CEFs more because I can invest in the manager, not the company. In the end, we all want to sleep at night, with our investments making us money. Enjoy and Happy Investing.
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Disclosure: I am not a financial advisor or money manager, and any knowledge is given as guidance and not direct actionable investment advice. I am an Amazon Affiliate. Please research any investment vehicles that are being considered. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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