Income investors usually pursue one goal and that is a stable and predictable cash flow. For many, the monthly or quarterly dividend payment is more than just a bonus - it is the heart of their investment strategy. But what happens if these dividends are suddenly reduced or canceled altogether? Especially with popular high-yield vehicles such as mREITs (Mortgage Real Estate Investment Trusts) or BDCs (Business Development Companies), this risk is real.
Capital Stack (Source: marketrealist.com)
However, instead of foregoing such investments altogether, it may be worth taking a closer look at the capital structure of these companies - or more precisely, at the so-called capital stack. This is where you will often find attractive interest-bearing alternatives to ordinary shares, such as Preferred shares, Baby Bonds or Noteswhich not only promise stable returns, but are also structurally better secured.
Capital structure
In corporate financing, the capital stack describes the order in which capital providers are served in the event of liquidation or restructuring of a company. At the top of the stack is the Senior Debtin other words, senior debt instruments. The following Subordinated debt and Preferred sharesbefore, at the very bottom, the Common Sharesi.e. the ordinary shares.
The lower an investment is in the capital stack, the greater the risk (simplified) - but also the potential upside. Conversely, the higher you position yourself in the stack, the more stable the expected cash flow - albeit usually with limited price potential.
For income investors, the question is therefore often decisive: Do I want high dividends with high risk, or would I prefer predictable distributions with increased security? Those who prefer the latter will find interesting alternatives in the upper part of the Capital Stack.
Examples
Preferred shares
Preferred shares are a widely used financial instrument in the USA, issued primarily by REITs, financial institutions (i.e. banks, etc.) and BDCs. They are a kind of hybrid between a share and a bond: they are listed similarly to shares, but usually have a fixed dividend rate - similar to a coupon payment for bonds - and are issued at USD 25 each. However, a preferred share can have many other features, e.g. it can be "called". However, the company does not necessarily have to do this. The call is then also made at USD 25 (occasionally there are deviations), regardless of whether the share price is below this level.
A great advantage: Dividends on preferred shares must be paid in full before a single cent can be distributed to common shareholders. In practice, this means that preference shareholders often continue to receive dividends in times of crisis, while the ordinary dividend is reduced or canceled.
Preferred Shares Details (Source: quantumonline.com)
One example: KKR Real Estate Finance Trust (TWS ticker KREF), an mREIT that invests in commercial mortgages, did not fare so well with investors when interest rates were raised sharply, mainly due to the office portion of the portfolio. The ordinary share is therefore more volatile - and investors are pondering the sustainability of the dividend. The KREF PRAThe preferred share of the company, on the other hand, offers a fixed coupon of 6.50 % (with call option) - and ranks above the ordinary share in the capital stack. And the share price is currently only just over USD 18!
IIPR Preferred Share (Source: TWS)
Another example is Innovative Industrial Properties (TWS ticker: IIPR), a REIT specializing in cannabis real estate. Here, too, there has recently been speculation about possible dividend cuts, as some important anchor tenants are currently experiencing problems. Anyone who still wants to participate in the stable rental income but fears a loss of the ordinary dividend could switch to the preferred share (TWS ticker: IIPR PRA) or one of the outstanding Notes (e.g. the 5.50 % Senior Notes due 2026).
Baby Bonds
Baby bonds are nothing more than listed corporate bonds aimed specifically at private investors. They typically have a nominal value of USD 25 (instead of USD 1,000 for institutional bonds) and are traded on exchanges such as the NYSE or Nasdaq.
These are often subordinated bonds (subordinated debt), which are serviced after the senior debt but before the shares in the event of insolvency. They offer fixed coupons, quarterly interest payments and usually have a term of between 5 and 10 years.
One aspect is transparency and liquidity: unlike traditional bonds, baby bonds can be bought and sold on the stock exchange like shares - which makes them ideal for income-oriented private investors.
Many BDCs, such as Gladstone Capital (TWS ticker GLAD) or OFS Capital (TWS ticker OFS), finance themselves via baby bonds, which can offer yields of 7 % and more - with manageable risk as long as the company is solidly positioned.
Classic bonds
In the USA, notes are the collective term for bonds with a medium term - usually between 2 and 10 years. In addition to preferred shares, many listed REITs or BDCs primarily use notes for refinancing, often with a fixed interest rate and repayment at par value.
In contrast to preferred shares or baby bonds, notes can be collateralized debt obligations which means better creditor protection in the event of an emergency. Investors looking specifically for senior secured notes can sometimes find very attractive opportunities.
An example: The above-mentioned note from IIPR (CUSIP: 44988FAD2) has a 5.50 % coupon maturing in May 2026. At the current price below par, this results in an even higher effective yield - with significantly greater security compared to the ordinary share.
Common share vs. note
The example of Innovative Industrial Properties also shows quite clearly how the common shares have performed compared with the notes.
Investment in IIPR (Common Shares)
- Entry course at the beginning of 2023: approx. 100 USD
- Dividend yield (ongoing): ~7-8 %
- Share price development until April 2025: around -50 % (current price ~50 USD)
- Dividends have been paid to date, but a reduction is on the cards
- Total income: negative, despite high current income
Investment in IIPR 5.50 % Senior Notes 2026
- Entry course at the beginning of 2023: approx. 90 USD (below par)
- Fixed coupon: 5.50 % p.a., quarterly payment
- Course currently closer to Par price (approx. 95 USD)
- Yield-to-maturity: approx. 10%
- Total return: constantly positive
Risks
As attractive as these instruments may seem, they are of course not a free lunch! Baby bonds or preferred shares of highly indebted companies in particular can default in an emergency. It is therefore important:
- Balance sheet analysisHow much debt is already in the stack? What is the interest coverage ratio?
- Liquidity checkCan the company service the interest and dividends even in the event of a crisis?
- Call riskMany preferred shares or baby bonds can be called early - usually at par value. Anyone who buys above par risks capital losses.
The Rating
Another frequent criticism of baby bonds or preferred shares is the rating: "They don't even have a rating!" Or even worse: "It's all non-investment grade, so I'd rather keep my hands off it."
In fact, many of these instruments either unrated are - i.e. have not received an official rating from Moody's, S&P or Fitch - or are in the area of BB or lower (High Yield) be classified as high risk. However, this does not necessarily mean that the issuer risk is high.
KREF Preferred Share (Source: TWS)
Especially in the case of smaller REITs or BDCs, companies often forego an official rating in order to save costs - because a rating process is expensive and ties up resources. And for relatively small issues (e.g. volume of USD 100 million or less), the effort is often not worthwhile from the company's perspective.
What does this mean for investors?
- No panic with "unrated" or BB ratings - The fundamental analysis of the issuer is more important.
- Interest coverage ratio and Leverage ratio (debt/equity or net debt/EBITDA) are more meaningful than a label.
- An unrated preferred share of a REIT with a conservative balance sheet and stable cash flow may, under certain circumstances safer than a BBB rating for a company with a cyclical business model.
In short, the lack of a rating is a risk signal - but not a criterion for exclusion.
Sources & Tools
Specialized databases are helpful in the search for suitable preferred shares or baby bonds, e.g:
- QuantumOnline.com - Extensive database on preferreds and baby bonds, including call dates and coupons.
- PreferredStockChannel.com
Preferred Shares Details (Source: quantumonline.com)
It is also worth taking a look at the Investor Relations pages of the respective companies - here you can usually find the terms of the bonds and preferred shares in detail.
Conclusion
For income investors, looking beyond ordinary shares can be extremely valuable. Preferred shares, baby bonds and notes offer attractive opportunities to position yourself strategically in the capital stack - and thus achieve stable returns even in volatile markets.
Especially when the dividends of mREITs or BDCs come under pressure, these alternatives can help to secure the income portfolio - and at the same time open up interesting opportunities for returns.
