Will Preferred Stocks Hypnotize With Yield?

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Will Preferred Stocks Hypnotize With Yield?

With such unattractive yields on savings rates, it’s no surprise to find more and more investors abandoning high quality fixed income products for preferred stocks. However, many of these investors may not comprehend the risks they are taking. Despite the appearance of stability, preferred stocks can become especially volatile when markets are reeling.

A helpful way to review preferred stocks is by studying the iShares Preferred Stock ETF (PFF). This index fund holds 312 preferred stocks and has a current SEC Yield of 5.52%, which is quite a bit more attractive than a Treasury Note under 2% or a CD under 1%. But before you run out to purchase preferred stocks, you should first seek to understand why preferred are yielding such a generous return.

While all investments carry some level of default or loss risk, this is more obvious in some investments than others. When you purchase high yield (junk) bonds, you know from the outset that these animals have a wild side to them. The same is true for most any stock but especially emerging market stocks. Preferred stocks, on the other hand, sound like a better trained and more domesticated breed – that is until you begin a closer inspection.

If you only look at the recent past, you might be lulled into an illusion of stability. For the last five years, PFF has held to a narrow trading range around $40.00 and dividend payments have been paid consistently (dividend payments are denoted as a “D”):

PFF 5-Year
PFF 5-Year Historical Price Chart (Google Finance)

However, if you look back to the inception of this fund, you’ll uncover a more complicated story. On May 1, 2007, this fund was priced at $50.00 per share and paying a 6.85% yield. However, during the financial stress of 2008 and 2009, this same fund dropped down to $15.05 a share.

PFF Since Inception
PFF Historical Price – Since Inception (Google Finance)

It is the nature of preferred stocks to have a very stable stock price – until they don’t. Their stability is derived from the fact that as long as they can pay their dividend, they maintain a stable price. However, preferred stock is more commonly used by financial companies that have a weaker balance sheet in order to appease regulators.

In a bankruptcy, preferred stock shareholders get paid back before common stock holders but after bond holders. This means that the preferred shares will have a lower credit rating than bonds from the same company. Of the 687 preferred stocks available for purchase at Charles Schwab, only 164 (24%) are investment grade.  When the financial sector experiences stress again, the stability of preferred stocks will come undone.

Even if you were to focus entirely on the highest caliber of preferred stocks, you run into another troubling feature Рinterest rate risk. Preferred stocks generally have a perpetual maturity (have no maturity) or are issued with a very long term between 30 to 50 years.  This means that if prevailing interest rates double, preferred stock holders will be stuck with current dividend rates for the duration. Rising rates further depress preferred stock prices. In the past, higher yields were often offset by stronger balance sheets which can help guard against downward price pressure but this appears to be an unlikely scenario in the new normal of muted economic growth.

Perhaps the biggest strike against preferred stock investing is that individual investors are not privy to all the tax advantages these instruments offer. Corporations who receive preferred stock dividends are typically allowed to exclude 70% on their tax return. This has the effect of increasing the price and risk for individual investors who are unable to access this benefit.

It is not worth the risk to invest in preferred stock if you are unable to access all the benefits. In this persistent low interest rate environment, investors who want more than a 3% return will benefit by abandoning an income investing mindset and adopt a total return mindset. The former will push investors into more and more risky investments to maintain the same level of income. A total return strategy opens the investment universe to find growth through both income and capital appreciation. Investing in a globally diverse portfolio of stocks and bonds is the most savvy way to financially prepare for the unknown future that lies ahead.

Photo used here under Flickr Creative Commons.

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Matthew Illian was a Wealth Manager at Marotta Wealth Management from 2007 to 2016. He specialized in small business consulting, college planning, and retirement plans.