A great income play that could beat inflation

Let me tell you about an investment I’ve found that could bring you a very chunky income over the next eight years, and a solid capital gain to boot.

If you’ve been reading The Right Side for a while, you’ll know I’m on a mission to find you great ways to earn a decent return on your money. With interest rates at rock bottom, your savings are being destroyed by inflation – because the government wants you to spend your money instead!

So the yield hunt is on – and we need to be smarter than the average investor to find it.

Today I’ve got something that ticks the boxes…

A fixed return with inflation protection

Now, as you know, certain stocks and sectors fall in and out of fashion. But as far as I’m concerned, there is one type of stock that always has a place in my portfolio – stocks with a tasty yield.

Today I want to show you a stock paying a fixed coupon delivering over 8%. And unlike most fixed-interest opportunities, there’s an inbuilt firewall against serious inflation.

When it comes to income, I like to have some straight high-yield equities in my portfolio – that’s the Stephen Bland approach.

But because dividends can be cut, or even suspended altogether, I also like to have a decent slug of fixed-interest stocks… where the issuer is committed to my payout.

In the last few months, I’ve shown you corporate bonds paying around 10% – and more recently, we looked at some preference shares with a similar fixed payout.

And seeing as the banks continue to take the mick (the jokers at my branch pay me less than half a percent on my deposit account), I’m still on the lookout.

But I know that many readers are concerned about stocks with fixed coupons. While they may look great in this environment, there’s no doubt that they could suffer if inflation makes a comeback. And with current central bank policies, the spectre of the seventies looms. I accept that.

For the benefit of our younger readers, during the seventies inflation ramped up to 26%. If we get that again, it could be a real killer!

But I think I may have found just the right investment for you today. It should pay you an inflation busting income – and give you a chance for a decent gain on your capital too.

This preference share is a great addition to your portfolio

You’ve probably heard of Balfour Beatty (LON:BBY) – Britain’s largest construction business. It operates in 80 countries and is involved in many of the major infrastructure projects you read about. It’s a FTSE 250 stock, with a market cap of over £2bn and it yields around 5%.

That’s not bad. But it kind of loses its appeal when you put it alongside what I want you to see. What I’m interested in is the Balfour Beatty 10.75% convertible preference share (LON:BBYB).

Now, before you get too excited, let me just tell you that the payout isn’t quite as generous as its name suggests. This preference share currently trades at £1.26. That means the running yield is more like 8.5% (10.75/£1.26). I’ll come back to the gross redemption yield later.

A yield like that from a solid multinational company operating outside the finance sector has merit. And with it being a preference share, the company is committed to pay your dividend. If, for whatever reason it can’t, then the dividend accumulates, and it’ll have to make good your payments before it pays regular shareholders anything.

But let’s get back to inflation, because we know that it could kill our returns. And with the central banks experimenting with the monetary system, anything could happen. I recently heard inflation likened to tomato ketchup. Nothing comes out, so you give it a whack, again and again – and then suddenly it all comes flying out. A plate full of the stuff!

That’s why we may need some protection. (Remember, that’s why it’s crucial to own some physical gold – and, the more I think about it, some decent gold shares.)

And these Balfour prefs could do the job too. Let me explain how it works.

Fixed interest, with a dash of inflation protection

Balfour’s preference shares have a fixed redemption date. In July 2020, just under eight years away, shareholders get a pound back for each share they hold. But if inflation has taken off in the meantime, not only will the value of your dividend have been diluted, but your £1 redemption may look pretty paltry…

With 10% inflation over the eight years, the real value of £1 will be more like 47p. At 20%, a quid will only be worth 23p in today’s terms.

That’s how fixed income investors got slaughtered during the seventies. So I accept why some readers question the merit of holding bonds right now.

This is why equities can provide great inflation protection. If general prices go up, then Balfour Beatty can raise its prices too. Providing they can maintain margins, then the nominal value of money doesn’t really matter (on longer projects they can even get contracts where payments rise with inflation).

If inflation doubles the price of everything, and Balfour can maintain margins, profits will double. And one might expect the shares to double too. Investors are protected.

That’s why it’s kind of nice that, come 2020, these prefs can be converted into ordinary shares…

For every 100 prefs held, holders can take 24.69 ordinary shares (ords). Now that could really take the sting out of a nasty inflationary shock…

Today the ords cost around £3 in the market. Now, let’s say we hit an inflation problem. Let’s say that over the eight years between now and redemption, inflation has averaged 10%.

Now, if (and I know this is a big if!) the shares move along with inflation, then the stock would ramp up to £6.43. So instead of taking a hundred devalued pounds, holders could take ordinary shares worth almost £160 (£6.43 x 24.69).

Some important points to consider

Now remember earlier I said the preference shares have a running yield of over 8%. But you might have spotted that if the shares are redeemed at £1, yet they currently cost £1.26 to buy in the market, there’ll be a capital loss to contend with. So we need to take that into account.

When you include the 26p loss on each share, then the effective yield is just over 6%.

That’s still not a bad return. If you look at high quality corporate bonds, you’ll find most of them yielding well under 5%. And though I haven’t got time to run through the tax side of things here, for private investors, preference share dividends are much more tax efficient than bonds.

But it’s the ability to convert the prefs to ords that could be an interesting kicker. There’s a tipping point when, instead of taking the £1 redemption, it’d be better to convert to ords. And that point is when (and if) Balfour’s shares hit £4.05.

Although Balfour’s ords trade at just over £3 today, bear in mind that, before the tumble of 2008, they were up at £5.

It’s not inconceivable that, come 2020, holders will be able to convert and make a handy profit in addition to the 8% running yield. Who knows?

I like the fact that this is a big solid multinational with a very healthy balance sheet. But of course we have to be aware that Balfour can, like any other business, hit troubled times. Preference share payments can be suspended and the shares may never recover to former glories.

But all in all, I reckon the Balfour Beatty 10.75% convertible preference shares (LON: BBYB) look like a decent addition to a diversified portfolio. Let me know your thoughts.

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