It's rare that an asset class can play many roles. Even more rare when such an asset class is barely on the radar screens of advisors and investors. But preferred stock is such a security, with the potential to provide yields and returns that rival those of conventional bonds and equities.
Preferred shares make up only a tiny share of the stock market. They aren't found in most separately managed or mutual fund portfolios. Just a couple of Wall Street firms provide research on them. The category is usually ignored when managers allocate assets. And financial journalists rarely write about them.
But preferred shares merit some attention, experts say.
Take the MetLife Preferred B shares. In January, their current yields were nearly 50% more than the insurer's February 2021 bonds: 6.57% versus 4.54%, according to Barry McAlinden, a fixed-income specialist at UBS Wealth Management Research.
"There's more assumed risk with the preferreds because they are lower down the capital structure and don't mature," says McAlinden. "But at the end of the day, both securities are backed by the same company, and it would not be in MetLife's interests to miss any payments."
Preferred shares come in many variations. Some are essentially bonds (Baby Bonds); others are backed by debt that's placed in a trust (Trust-Backed Preferreds); some offer dividends, of which 70% are deductible from corporate taxes (Dividend-Received Deduction Preferreds); and some never mature (Perpetual) and pay dividends that are taxed at 15% (QDI-eligible) regardless of an investor's tax bracket.
Preferred shares are securities issued by domestic and foreign companies to raise capital in U.S. dollars with no foreign currency risk. Preferreds rank below bonds when it comes to dividend payment priority, but above common stocks.
During the 2008 financial meltdown, preferred stocks showed themselves to be resilient, with most preferreds continuing to pay dividends through the crisis. The reason, according to Brian Gonick, principal of Senvest International, a New York-based hedge fund with a contrarian bent, is that a dividend suspension puts a company's reputation at risk, which over the long term can be costlier than paying the dividends.
But a few major issuers did fail, including Fannie Mae and Freddie Mac (which, as government-sponsored enterprises, gave investors the mistaken belief that they would be backstopped by Washington D.C.), along with Lehman Brothers and Washington Mutual.
Advisors should note that regulators are considering rules that would force preferreds issued in the future that are treated as reserve tier one capital to convert to common stock once a company's finances deteriorate below a certain threshold and before taxpayers are asked to bail it out, says McAlinden. If such regulations come to pass, it could make existing preferreds all the more valuable because they would be exempt from this risk.