With interest rates at a 40-year low, some financial advisors are parking cash in preferred stocks, which yield 8%.
Preferred stocks have attractive features, often overlooked by clients seeking high current income. For one thing, fully taxable preferred stocks are among the highest-yielding investments.
Typically, preferred stocks are issued by strong, highly rated companies, such as utilities, banks and financial services corporations. Also, because preferred stock are not highly correlated with other asset classes, they can potentially decrease portfolio volatility and enhance overall return.
"Preferreds are a good way to round out a fixed-income portfolio," says John Catalfamo, managing partner of Primoris Capital Management, Singer Island, Fla. "The yields are high. But I'm only investing for the short term. It is a good way to mark time in a bear market."
Preferred stocks, like bonds, are highly sensitive to changes in interest rates. Although preferred stock is listed on a company's balance sheet as equity, it is considered a fixed-income investment. A preferred stock has a fixed dividend. Owners of preferred stock have no voting rights. However, they have priority over common stockholders in the event of bankruptcy. Most preferred stock issues are callable.
Catalfamo largely keeps his clients in short-term notes that mature in two years or less. He doesn't want to extend maturities because rates could rise and bond prices could decline. Instead, he is investing a small amount in preferred stocks issued by companies with strong balance sheets and high debt coverage ratios. Although preferred stocks values also are subject to changes in interest rates, they're typically less volatile than bonds.
Catalfamo says he will sell his preferred stock if rates rise. He also will sell if a company's financial condition changes or Standard & Poor's puts an issue on a credit alert.
On the plus side, Catalfamo believes preferred stock could become an even more attractive investment if the Tax Simplification Act of 2002, introduced by Rep. Rob Portman, R-Ohio, is adopted. A provision in the bill would exempt the first $500 of dividends or interest from federal income tax.
Thomas Grzymala, an advisor with Alexandria Financial Associates, Alexandria, Va., says he has about 20% of his clients' fixed-income portfolio in preferred stocks. They include Citigroup, JP Morgan, SunTrust and Duke Energy.
"We are putting a small portion of our clients' new money into preferred stock as a parking place," Grzymala says. "But I have stop losses on the stocks. If my indicators are negative, I will sell them for a profit."
Most preferred stock issues are cumulative. In other words, the dividends will accrue even if they are not paid. So if a company has to cut its dividends to reduce costs, preferred dividends are accrued. Once dividends are resumed, preferred shareholders are paid their accrued dividends.
Preferred stockholders' rights to the dividends can prove invaluable in a worst-case scenario. Here's what happened during the Great Depression in the 1930s, according to a 1942 Ph.D. dissertation by Roger F. Murray, for the Graduate School of Business, New York University.
Of the 243 industrial preferred stocks traded on the New York Stock Exchange, 41% paid their full dividends every year. Another 24% paid up arrears in cash within a reasonable time. The rest, however, lost out.
There are advantages and disadvantages to investing in preferred stocks.
On the plus side, they offer attractive yields. The Merrill Lynch Hybrid Preferred Index yields 8%. By contrast, the Lehman Government Bond Index yields 4%.
Corporations can get a 70% dividend-received deduction (DRD) by investing in preferred stocks. Only 30% of the corporation's income is taxable.
Individual investors can purchase taxable preferred stock. These issues pay higher yields because they do not qualify for the dividend-received deduction. Preferred stock also can be less volatile than long-term bonds. In weak markets when interest rates rose, the Preferred Income Fund, a closed-end preferred stock fund, lost just -2.4% over 136 months ending in May 2002, according to Lipper data. By contrast, the Lipper Composite of Investment Grade Bond Funds lost -7.2%. During the entire holding period, however, the preferred fund underperformed bonds.
There is no free lunch with preferred stock. The stock can be called. It could be subject to a sinking fund when the issuer retires a certain percentage of the total issue over a specified period of time. Recently, the Bank of New York, and Public Storage redeemed their taxable preferred issues.
A company may suspend the preferred dividend during tough economic times, using the realized savings to pay down debt or pump money back into the company to improve sales. So when a company's bottom line improves, the common stockholders benefit from higher stock prices at the expense of the preferred shareholders.
What's more: The securities are subordinate to bonds. The stocks are thinly traded compared with common stocks. So bad news about a company could drive preferred stock prices down.
"I don't invest in preferred stocks," says James Midanek, financial advisor with Midanek/Pac Advisors, Walnut Creek, Calif. "You have interest rate risk and equity risk. Those looking for income should invest in a corporate bond fund with a duration of five years."
By contrast, Greg Phelps, manager of the John Hancock Preferred Income Fund, says a diversified portfolio of preferred stocks fits nicely into a fixed-income or even an equity portfolio. "The preferred stocks are more rate sensitive than stocks, but the fully taxable preferreds are less volatile than bonds," says Phelps, whose closed-end preferred stock fund yields 8%. "They are paying attractive yields."
Correlations of preferred stocks to most other fixed-income vehicles are surprisingly low. The total return of the Merrill Lynch Hybrid Preferred Index, he explains, has a 0.48 correlation with the Lehman Brothers Aggregate Bond Index, a .36 correlation with the Lehman Government Bond Index, a .08 correlation with the NAREIT Equity Index and a -.01 correlation with the S&P 500.
Unfortunately, there are no diversified open-end preferred stock funds. Vanguard merged its Preferred Stock Fund into the Vanguard Convertible Securities Fund more than two years ago. The Convertible Securities Fund yields 5.10%. The fund invests at least 80% of assets in convertible bonds. Twenty percent is invested in preferred stocks and the rest is in corporate bonds and cash.
Closed-end preferred stock funds are the only alternative to buying individual securities. There are nine closed-end preferred stock funds tracked by Lipper. On average, the stocks are trading at a premium to their net asset values. Their yields range from 6.5% to over 8%. Meanwhile, the market prices of the funds are in the black this year.
The John Hancock Preferred Income Fund is the only closed-end preferred stock fund that invests exclusively in taxable preferred stocks. The universe of taxable preferred securities has grown to $200 billion since 1993.
The other closed-end funds typically invest in dividend-received deduction preferred stocks. As a result, Phelps' fund will pay a higher yield than the eight other closed-end preferred stock funds tracked by Lipper.
Phelps says taxable preferred stocks have been less volatile than bonds. The reason: Large recognizable names sell the stock at a par value of just $25 a share. So individuals tend to buy and hold these securities.
Phelps only invests in fully taxable cumulative preferred stocks with five-year call protections. The average credit rating of his holdings is BBB. But 80% of the fund is invested in investment-grade bonds. The rest carry B ratings or are unrated. These lower-rated issues, however, have stronger balance sheets than their peers.
By contrast, Donald Crumrine, co-manager of the Preferred Income Fund, says he's been gradually selling his taxable preferred holdings. He is buying more dividend-received deduction preferred stocks because they are undervalued. The fund invests in investment-grade preferred stocks primarily in the utility, banking and financial sectors. Its largest holdings include Wells Fargo, Bear Stearns, USA Education and JP Morgan.
"We have continued to sell gradually some of our holdings of hybrids," Crumrine says. "We are buying attractive, traditional fixed-rate preferreds as opportunities have appeared in the market."
Phelps, of John Hancock, focuses on regulated utilities in his fund. The fund will keep at least 25% in this industry. "Regulated and regionally focused utilities have a high level of visibility," he says. "They have predictable earnings and low business risk."
The fund also invests in bank, insurance, brokerage, oil and gas, and a smattering of highly rated industrial preferred stocks. Phelps wants to own companies with strong balance sheets, growth rates relative to peers and low relative valuations. He also looks to see if management's compensation is tied to the performance of the company. He is sticking with a universe of big-name issuers that include J.P. Morgan, FleetBoston, Merrill Lynch, Alabama Power and El Paso Tennessee Pipeline.
The fund uses leverage on 30% of the portfolio to boost yields. But there is danger on the down side if interest rates rise. So to reduce the risk, Phelps says he will typically shift to high coupon issues, buy high dividend yielding common stock and increase his cash positions. The fund will also short Treasury futures to offset interest rate risk.