Two advantageous investing vehicles for perennial income

Though inflation is projected to decline in the coming months, it’s likely to linger, possibly for years, at levels far above those of the past decade. Higher inflation is a current global phenomenon, and the U.S. is by no means immune.

Although bond yields have been rising steadily with interest rates during the past few months, a yawning gap between yields and inflation may continue for years.

For bond investors, this would mean a protracted period of negative net bond yields — losing money after inflation.

Thus, there’s a challenge for investors who want to generate reliable positive income: How can they protect their wealth from inflation’s erosion of buying power if the traditional solution — bonds — won’t do this job? Unbeknownst to investors whose horizon is limited to stocks and bonds, there are alternatives. Two of these currently stand out as being particularly advantageous: real estate investment trusts (REITs) and preferred stocks.

For the last couple years, these income vehicles have been paying far higher rates than bonds. Currently, they’re a great buy and can serve as a long-term solution to investment income challenges in an environment where bond yields may start to decline next year. This will probably happen if the Federal Reserve Board pivots and starts cutting interest rates.

REITs

These publicly traded companies own and lease out various types of property. They’re excellent income producers because their special tax status requires them to pay out 90% of their pretax income to investors in the form of dividends.

REITs had a nice run-up in 2021, making real estate one of the best-performing sectors. This year, however, REITs have been one of the worst.

Many REITs currently provide dividend yields upward of 5% — and some, higher. Although the yield of the two-year Treasury Bond edged over 4% in September 2022, investors will never get a raise in income from these, and their bonds would lose value on the secondary market if yields on new two-year issues are higher. By contrast, REITs can offer the best of both worlds: rising total return from gains from share-price appreciation and from superior income.

And if market history is any guide, this category stands to rise substantially after recouping its 2022 losses. Since 1994, in six-month periods after the end of Federal Reserve interest rate-increase cycles, REITs on average have returned nearly 35% — about 16% more than the S&P 500 stock index.

Here’s a look at current market conditions of some prominent REIT categories:

Apartments. Rising construction costs and mortgage interest rates are becoming prohibitive for more and more wannabe homebuyers, increasing pressure on apartments. Atop this, recession-fearing banks are starting to pull back financing for building new complexes. These factors make existing complexes more valuable, enabling REITs owning them to continue jacking up rents to cover increasing costs.

Office space. Still a shadow of its former self after heavy damage from the pandemic, this category has bounced back a bit and now shows promise as more companies shift from remote workers to requiring more days in the office. An example is SL Green Realty Corp. As the largest owner of property in New York City, this REIT is a dominant force in office leasing in the Big Apple.

Medical/nursing space. This category includes doctors’ office suites, hospitals, rehab centers and various levels of care for older adults. With ultra-long-term leases in many cases, these REITs haven’t been able to raise rents as quickly as some other categories to defray rising costs, and they’ve been dealing with escalating wage increases in the current high-demand employment market. Yet, offsetting these factors is the deep well of demand from aging baby boomers. Companies to look for include those with strong senior housing holdings. Examples include Ventas (VTR) and Welltower (WELL), which owns post-acute-care centers.

Cell towers. With 5G proliferating, demand for leases on towers that conduct this signal, part of the digital tsunami, continues to rise. Because relaying the 5G signal requires more smaller towers, companies with long records of siting new ones are the most attractive. These REITs are currently a bit pricey, but they have legs. Examples include industry leaders American Tower (AMT) and Crown Castle (CCI).

Preferred stocks

Foreign to most individual investors, these stocks are something of a bond-stock hybrid issued mainly by banks, insurance companies and other financial institutions. More complicated than bonds and common stocks (what people mean when they say “stocks”), these investments behave more like bonds, with returns that are almost bond-like in their reliability. Though more volatile than bonds, this relatively small universe of assets characteristically poses less risk than common stocks.

Credit ratings of preferred stock issues, as with bonds, are critical to value. Generally, these ratings may never have been higher. Stiffer rules on capital requirements for financial institutions and close monitoring by regulators, spurred by big banks’ role in the problems leading to the financial crisis of 2008, have resulted in strong balance sheets with far less leverage.

Currently, yields are higher than they’ve been in more than 20 years — 6.5% to 7% in many cases. By buying now, investors can lock in high yields on some issues before they begin to decline. Although preferred stocks tend to carry more risk than federal-tax-free municipal bonds, their net yields are higher on an after-tax basis because their dividends are qualified income, meaning a maximum tax rate of 20%. The maximum tax rate on income from bank CDs and taxable bonds is 37%.

Investing in preferred stocks is more complicated than in bonds or common stocks. One type that’s especially tricky is callable preferred stock. When issuing these shares, companies reserve the right to buy shares back from the purchaser at a set price whenever they choose after the call date. Owners of these shares may not have time before calls to accumulate enough income from the shares to justify the purchase price relative to the preset call price. This situation is known as negative yield to call.

This and other complexities mean that many individual investors are better off investing in preferred shares through funds. When buying these, it’s usually best to stick with actively managed funds (as opposed to passively managed) because this is the only surefire way to avoid funds holding troublesome shares with negative yield to call. Though some actively managed funds may own shares with negative yield to call, fund managers can minimize exposure to them.

Investors who lack sufficient financial knowledge — and/or available time — to research preferred stocks might want to discuss this area with a qualified advisor instead. Regardless of which route you take, preferred stocks can be a fairly reliable source of income with significant tax advantages.

Dave Sheaff Gilreath, CFP, is a 40-year veteran of the financial services industry. He is a partner and chief investment officer of Sheaff Brock Investment Advisors LLC, a portfolio management firm for individual investors, and Innovative Portfolios LLC, an institutional money management firm.

Edward “JR” Humphreys II, a chartered financial analyst and a chartered alternative investment analyst, is a senior portfolio manager for both firms, concentrating on fixed-income and alternatives investments. Based in Indianapolis, the firms manage approximately $1.4 billion in assets nationwide.