As an investor focused on generating a consistent stream of monthly income, my journey has involved a careful assessment of various high-yield assets. While the lure of high payouts can be strong, it’s crucial to understand the underlying risks. This post outlines my thought process, the investments I’ve considered and ultimately set aside, and my current preferred strategy for a potentially lower-risk approach.
Why Other High-Yield Investments Were Set Aside
My initial exploration led me to vehicles like AGNC Investment Corp. (AGNC) and Stellus Capital Investment Corporation (SCM), both known for their attractive dividend yields. However, a deeper look into their business models revealed specific risks that, for my personal strategy, were too significant to overlook.
AGNC (Mortgage REIT): My analysis showed that AGNC, as a mortgage real estate investment trust (mREIT), is highly susceptible to interest rate risk. Its profitability hinges on the spread between what it earns on long-term mortgages and what it pays on short-term borrowings. A rise in interest rates can compress this spread, hurting profitability and the company's ability to maintain its dividend. On the other hand, decreasing interest rates are likely to spawn a wave of refinances. Borrowers will certainly want to save money by borrowing at lower rates and reducing their monthly expenses. This prepayment risk means AGNC's high-yielding assets are paid off early, forcing them to reinvest at lower prevailing rates. Furthermore, the company's use of substantial leverage amplifies both gains and losses, making it a potentially volatile investment.
SCM (Business Development Company): Investing in a business development company (BDC) like SCM presents a different but equally potent set of risks. SCM’s income is generated by lending to small and mid-sized private companies. The primary risk here is credit risk—the possibility that one of these portfolio companies could default on its loan. This could lead to a loss of principal and a direct impact on SCM’s income. Additionally, the valuation risk of these private assets is not as transparent as publicly traded securities, which could lead to unexpected write-downs and a decline in the company’s net asset value.
My consideration also included PFFV (Global X Variable Rate Preferred ETF). While this ETF offers a distinct advantage over fixed-rate preferreds in a rising interest rate environment—as its dividend payments can adjust upwards—it carries a significant risk in a declining rate environment. Because PFFV invests in variable-rate preferred stocks, the income it generates would also decrease as interest rates fall. This could lead to a lower share price and a reduced dividend for investors, making it a less attractive option for those who anticipate falling rates.
While AGNC, SCM, and PFFV have the potential for high returns, their specific risk profiles—rooted in interest rate volatility and credit quality of private companies, respectively—led me to lean towards an alternative that felt more stable for my long-term income goals.
My Preference for simple Preferred Stocks
This led me to consider preferred stock ETFs, specifically the iShares Preferred and Income Securities ETF (PFF). Preferred stocks are a type of security that is higher in the capital structure than common stock, meaning preferred shareholders have a senior claim on a company’s assets and earnings. This provides a layer of security not found in common stock.
The ETF structure of PFF further mitigates risk through diversification. By holding a broad portfolio of preferred stocks from a wide range of companies, the impact of a single company's default is minimized.
However, PFF is not without its own risks. As the ETF primarily holds fixed-rate preferred stocks, it is subject to interest rate risk. When interest rates rise, the value of the fixed-rate payments becomes less attractive, causing the market value of the underlying securities to fall. Conversely, in a falling rate environment, the fixed-rate payouts become more desirable.
My Strategy and Outlook
Based on recent news and the data I've reviewed, I've formed a specific outlook on the future direction of interest rates. It appears that President Trump is adamant about seeing interest rates reduced and has expressed his desire to influence Federal Reserve appointments to achieve this objective.
My belief is that a deliberate effort to lower interest rates will have a mixed economic impact. It may reduce the amount of money "paid-out" to the public through interest and savings accounts and could cause greater hardships for businesses operating on thin margins, but it would likely reduce expenses for consumers, potentially leading to a period of deflation.
With this conviction in mind, and based on the understanding that fixed-rate preferred stock values tend to rise when interest rates fall, I will be using a time-sensitive Dollar Cost Averaging Strategy to increase my holdings in PFF. This approach involves investing a fixed amount of money at regular intervals, which helps to mitigate the risk of buying in at a market peak. My belief is that this strategy will position me to benefit from the capital appreciation and steady income that a lower interest rate environment could bring to PFF.
Disclaimer: This blog post is a reflection of my personal investment strategy and is for informational purposes only. It is not financial advice. You should always conduct your own research and consult with a qualified financial advisor before making any investment decisions. I own and reinvest the Dividends of all Investments mentioned in this post. I have not intention to sell any shares, at this time but as indicated, outside of Dividend Reinvestments, I will be allocating future Investment Capital towards PFF.