Stocks that pay dividends can be a great way of generating passive income for me as an investor. But dividend stocks can be risky investments.
Sometimes, companies can decide to reduce the amount they distribute to investors, or even stop paying dividends entirely. And when they do, not only does the passive income stream dry up, but the price of their shares can crash as a result.
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With stagflation and the possibility of a recession approaching, I’m increasingly wary that there are going to be more and more companies lowering or suspending their dividend payments. When economic conditions get difficult, businesses might need to keep their cash to survive. Alternatively, they might use it to fund growth opportunities as their rivals struggle. Either could lead to lower payouts.
Fortunately for me, I have a secret weapon that I’m using in my bid to build passive income.
In order to generate passive income that I can rely on when times are tough, I’m looking at buying preferred stock. Like common stocks, preferred stocks pay dividends to their owners. But unlike common stocks, management doesn’t have the same discretion over how much to pay out each year.
Two examples of companies that have preferred stocks that I can buy are BP (LSE:BP) and Aviva (LSE:AV). Both companies increased their dividends in 2018 and again in 2019 before lowering them substantially in 2020.
If I owned the common shares in these companies, then I’d have received good dividends before the pandemic. But when I needed it most–in the difficult economic times, my passive income would have deserted me.
By contrast, if I owned the preferred stock in each of these companies, my stream of dividend payments would have continued uninterrupted. BP’s 9% preferred stock distributed a 4.5p dividend to its shareholders twice per year. Aviva’s preferred stock distributed two payments of 4.375p each.
This is because preferred stock dividends are fixed. Take BP as an example. The preferred stock dividend isn’t raised when the company makes more money due to high oil prices are high, but it also isn’t lowered when the price of oil falls.
While management can decide not to pay a dividend at all in a particular year, the missed payments accumulate and have to be made in full before any dividends can be paid to common stockholders. That means that, sooner or later, I can expect to get the dividend payments I usually get.
I’m looking at buying preferred stock in both BP and Aviva for my passive income portfolio. At current prices, BP stock pays a 5% dividend and Aviva’s preferred stock has a dividend yield of around 6%. In both cases, this is attractive to me.
While preferred stock dividends have limited upside, they’re also less likely than common stocks to let me down in a difficult economic environment. That’s why they’re my secret weapon for building passive income.