Investing in Preferred Stocks as Interest Rates Rise

Preferred stock should play a useful role for income investors even in what is expected to be a rising rate environment. Indeed, with interest rates at what are still relatively low levels, when rates inevitably move up, bond prices go down. How will preferred stocks perform?

First of all, what is a preferred? A preferred stock is “preferred” on two counts. First, in the capital structure of the company, it is senior to the common stock of the company – that is, if the company were to be wound down or liquidated, the preferred stock would have to be redeemed prior to that of the common shareholder. But preferred stock is junior to all debt, i.e. the bank and the bondholders get paid first. Secondly, a preferred stock has priority in its dividend. The common shareholder cannot receive a dividend unless the preferred shareholder is paid first. (For more, see: A Primer on Preferred Stock.)

How They Differ from Bonds

There are three key differences here. First, the bond has priority. It makes its interest payments (known as coupons) first before any dividends are paid. Second, bonds have a maturity date. Typically, preferred shares don’t. Finally, the terms of a bond are determined by what’s called a bond covenant, a legally binding document much like your mortgage that enforces your rights as a “creditor” and that of the issuing company. It may have restrictions on the issuer’s ability to issue additional debt. Preferred covenants tend to be somewhat weaker, notably that, like the common stock dividends are payable “if, as, and when” declared by the board of directors.

Also of note, some preferred stocks have a cumulative feature which requires that if any dividend payments have been missed in the past, these dividends must be paid out to the cumulative preferred shareholders first, before other preferred shareholders and common shareholders.

The board has a very strong incentive to pay the regularly scheduled preferred dividend. Remember, nearly all management receive the bulk of their compensation through options on company common stock. Since the common stock would drop if its dividend were reduced or eliminated, management wants to maintain or increase the dividend on the common. To do so, the preferred dividend must be paid before any common stock dividend.

Because of their hybrid nature, a bit like a bond, a bit like a stock, preferreds have unique characteristics that investors will find useful in today’s rising rate environment.

• The yield relative to their debt counterpart is higher. 

• The yield relative to the common stock is higher. 

• For most preferred stock the dividend income is recognized as qualified dividend income (QDI), 
the same as most common stock dividends and therefore is taxed at a lower rate than bond income which is subject to ordinary income tax rates. 


Diversification

Preferreds also offer a great opportunity to improve portfolio diversification. That's because they have relatively low correlation (how closely securities move with one another – the lower the correlation, the greater the diversification benefit. Perfect correlation is 1.0) with both traditional fixed-income and equity assets. We have used the iShares US Preferred Stock ETF (PFF) for this comparison:

Correlations can change over time. However, as the above table demonstrates, adding some preferred securities given their relatively low correlations (below 0.7 is a good benchmark) should improve overall portfolio diversification. (For more, see: Why do Some Preferred Stocks Have Higher Yields than Common Stocks?)

Other Benefits of Preferred Shares

Higher yields relative to most other asset classes:
 The spread (difference in yield) between the average yield on preferred stocks and the 10-year Treasury is still quite large. The 12-month yield on PFF is currently 6.06% versus the 10-year Treasury bond at 2.55%, the AGG at 2.36% or the S&P 500 at 2.01% (based on closing prices as of December 21, 2016). Note that even compared to the junk bond fund JNK, which has a 12-month yield of 6.20%, the yield on PFF is similar despite having a better credit standing and less default risk.

Less volatility than most other asset classes:
 In addition, preferred stocks tend to have about 70% of the volatility than high-yield bonds and less than half the volatility of the S&P 500 (based on the last five years of history).

Unique hybrid structures compared to bonds:
 Some preferred securities have unique blended structures which may pay a fixed coupon for a number of years and then convert to a variable rate coupon for the remaining life of the security. With a variable coupon feature, these preferreds will capture future increases in interest rates – consequently, these types of preferred stocks are less affected by rising rates.

Focus on the improving financial services industry:
 Roughly 80% of all preferred securities are issued by the financial sector banks and insurance companies. As a result of more stringent capital requirements, U.S. bank balance sheets are much stronger and better capitalized than they have been for years. This balance sheet strength should result in a better risk perception and higher prices for preferred stocks.

The Risks

The risks of preferred shares are very similar to those of corporate bonds. 
Preferreds are also sensitive to interest rates but unlike bonds, these securities either never mature or will return principal only after 30 or 40 years. As interest rates rise fixed-income securities, such as bonds and preferreds, will fall in value. An investor can be stuck with a security that does not mature. However, in the relatively benign interest rate scenario that most economists envision, in which the rise in long-term interest rates is reasonably contained, preferred stocks with their higher coupons should perform relatively well compared to their bond equivalents.

Credit risk is also a concern. Troubled companies can suspend preferred dividend payments and in a bankruptcy, preferred shareholders will suffer market losses much like common shareholders. Many preferred shares carry credit ratings but there are plenty of others that are unrated. In our view, banks and insurance companies should benefit from a steepening yield curve that should bolster their earnings power.

Preferred stocks like most corporate bonds have call provisions which give the issuer the opportunity to redeem these securities early, generally no earlier than five years after issuance. Issuers call securities when they can be refinanced at cheaper levels or when the issuer has excess capital on its balance sheet. If the investor has purchased the preferred at a price in excess of that call price, he/she would have a loss. (For more, see: Preferred Stock Valuation.)

The Best Way to Buy Preferred Stocks

Often, ETFs represent one of the best ways to achieve a diversified portfolio in this asset class. An ETF allows investors to buy a diversified basket of preferred shares with the convenience of one purchase.

The largest and most liquid preferred ETF is PFF, the iShares US Preferred Stock ETF which is diversified across 296 holdings and uses the S&P Preferred Stock Index as its benchmark. The expense ratio, or management fee, is at the low end of its peers at 0.47%. The current distribution yield is just over 6%. According to S&P Capital IQ, the percentage of its exposure below investment grade is only 0.3%, so this ETF has a very high-quality portfolio.

Another choice is the PowerShares Preferred Portfolio (PGX). It tracks the Bank of America Merrill Lynch Core Fixed Rate Preferred Securities Index, which is also well established with a long track record and similar quality. It does include foreign preferred securities as well as some senior and subordinate debt securities. The yield is very similar to PFF, but the portfolio holdings feature on average slightly higher coupons which should reduce the relative volatility of this ETF. The expense ratio is similar at 0.50%.

For those who prefer an actively-managed mutual fund structure, an individual investor might consider the Cohen & Steers Preferred Securities and Income Fund (CPXAX) which has an expense ratio of 0.85%, well below the category average (according to Morningstar) of 1.23%. The performance over the last five years has been 9.50% annualized, versus PFF’s 7.23% and the broad bond market’s 2.19%. As you can see, there has been value added, even after expenses, in using this actively-managed fund.

Selecting individual preferred stocks can be challenging for the individual investor because of the many unique features of some preferred stocks, particularly call dates, Moody's and S&P ratings and the tax treatment. It does require a lot of time and effort to select individual names and research them adequately. A useful source of free information regarding preferred stocks (but supported through voluntary user contributions) is QuantumOnline.com.

Of course, there are investment managers and financial planners such as ourselves who are pleased to construct portfolios utilizing preferreds and tailor these investments according to an individual’s objectives and circumstances. (For more, see: What You Need to Know About Preferred Stock.)