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.
Bond-Like Characteristics
Because preferreds are largely yield plays, they tend to move like bonds. Their prices are affected by long-term interest rates, spreads over Treasuries and the credit quality of the industry and issuer. Profit fluctuations do not affect preferred share prices of healthy companies.
Preferreds come with call dates. This is when the issuer has the right to buy back shares-typically starting five years after issuance. The fact that a preferred can be called can keep prices of healthy companies from moving too far above or below par. Preferreds are called when a series is issued with a high coupon and rates have subsequently fallen, enabling the company to refinance at a substantially cheaper cost.
Mergers can trigger special opportunities by instantly altering risk. Before the private equity firm Apax Partners bought out Tommy Hilfiger, for example, the retailer was struggling and its preferreds were trading well below their $25 par price-the price at which the preferred was issued and at which it can be called. Paying a 9% coupon, these preferreds started to recover upon announcement of the deal and moved quickly toward par. The reason: Apax is a highly regarded firm with much cheaper access to capital. Retiring these preferreds was an instant way to cut costs, and the private equity firm did so at the first opportunity.
Fear and uncertainty can also drive preferred prices.
For example, an extraordinary buying opportunity was created during the height of the credit crisis. "For the first time since they became a major source of capital financing, preferreds got pummeled indiscriminately," says Greg Phelps, senior portfolio manager of more than $4 billion of John Hancock preferred funds. Instead of moving in response to interest rates, credit issues and yield spreads, many venerable preferreds tracked common shares, as fears of insolvency, reorganization or nationalization brought their values to unprecedented lows.
Deutsche Bank saw its $25 par trust preferred, with a coupon paying 6.37%, collapse from $20 in the middle of 2008 to below $5 in early March 2009, yielding nearly 32%. Deutsche Bank preferreds have since recovered, trading in January at about $22.
The return of stability to the credit market and recovery of preferred shares has likely brought an end to the recent rally. Robert Ettinger, president of Flaherty & Crumrine, which manages $4.1 billion in preferred stocks, says investors should expect future returns to more closely reflect current yields, in the mid-to-high single digits.
Senvest's Gonick, however, sees potential in certain shares whose dividends have been suspended. Despite having been rescued by the British government, which now owns 85% of the institution, the Royal Bank of Scotland continued to pay dividends on its preferreds until the European Commission ruled that, as of April 2010, it had to suspend payment on most of its preferreds for two years.
Gonick believes that without the ruling, RBS would've continued paying preferred dividends to sustain its standing in the capital markets. He believes that once the suspension period is over, RBS will reinstate the dividends. So he started buying these securities early last year when they were trading around $10, thinking of them as zero-coupon bonds. In mid-January 2011, they were trading above $17. If one presumes an 8.6% yield, which the performing RBS preferreds are currently paying, then the stock could return to the low $20s.
Buying Preferreds
More than 1,000 preferred stocks trade on U.S. stock exchanges, primarily on the New York Stock Exchange. There are several factors to consider before investing in them. If you're looking for secure income and the least volatile shares, experts recommend sticking with the highest-rated companies. Banking firm HSBC has a $50 par preferred Series Z that's currently yielding more than 6% and paying dividends that are taxed at 15%. It is cumulative, which means if the dividend is ever suspended, the bank cannot start paying dividends on its common shares before it makes up every missed dividend on this preferred. Further, this preferred offers a dividend-received deduction (DRD), which enables qualified corporations to deduct 70% of the dividend. Toward the end of January, that meant the pretax equivalent yield for such corporations was 8.36% for this "A-" rated security. Any preferred can decline in value at any time. But if one assumes interest rates and credit quality will remain fairly stable this year, these features can provide the HSBC issue with strong price support over at least the short term, making it an attractive alternative to nil-paying money markets.
REIT preferreds are also a good source of preferred income because the rally in their common shares has brought down their average dividend yields, Phelps says.
Insurance companies and brokerages have been significant issuers of preferreds, whose current yields are above 7%.
Investment-grade Dutch insurer Aegon has a preferred, for example, that was paying 7.7% in late January.
Fund Approach
Mutual funds offer a simple way to gain access to diversified portfolios of preferreds, including several low-cost ETFs. Flaherty & Crumrine's Preferred Income Opportunity Fund, for example, has delivered 10-year annualized gains of 7.73%.
The major concern of most actively managed preferred funds is that they are largely closed-end vehicles. This means their actual market values can deviate substantially from the underlying net asset value of their investments. This can turn profits into losses when the so-called discount between the two widens. But it also offers opportunities to buy assets on the cheap.
Using leverage to enhance the buying power of every dollar clients invest (bumping it up to as much as $1.50) enables closed-end funds to enhance yields and returns. The risks of doing so were exposed during the financial crisis, when leverage exaggerated the losses of declining preferred prices. When the market for auction rate preferreds (the source of leverage) froze, it forced fund managers to sell depressed preferreds at a bad time. The market value of closed-end fund preferreds were further hurt as investors fled these distressed situations. But most funds have since found alternative, more dependable sources of leverage. Investors have returned, and the discounts have shrunk to more traditional levels.
Caveats
Advisors need to consider the tax exposure of specific issues. Those that pay dividends are likely delivering income taxed at a 15% rate for as long as the Bush-era tax cuts are in effect. Preferreds that are backed by debt and paying interest are subject to income tax, creating a tax liability that can be at least twice that of dividend-yielding preferreds. Accordingly, trust preferreds are more appropriate for tax-deferred accounts.
While the low interest rate environment is not likely to change soon, borrowing costs will eventually rise. Preferred prices are based on spreads over ten-year Treasuries. This portion of the yield curve has moved up in recent months, even while the Fed has kept overnight rates steady. This may suggest that even when the central bank starts to normalize rates, long rates may remain stable. The reason: The market may worry less about inflation if it sees the Fed moving against it. And long rates are largely a measure of inflation expectations.
Currently, according to the Bank of America Merrill Lynch Preferred Stock Fixed Rate Index, the average preferred yield is around 7% or 358 basis points above ten-year Treasuries, which were yielding 3.42% to maturity at the end of January. But if Treasury yields were to permanently exceed 4.5%, preferred yields would likely bump up an additional 100 basis points. This would mean a corresponding decline in preferred share prices to affect this yield shift.
The two-year rally preferreds have enjoyed is presenting another risk. Investors should generally avoid higher coupon shares selling above the call price if the issues are presently callable since they can lose the entire premium paid above call at any time.
As previously mentioned, financials may also be affected by regulatory changes to what may be counted as capital reserves. Regulators, for example, are taking aim at hybrid preferred securities. These issuances soared prior to the financial crisis because they could account for up to 15% of a financial's capital reserves.
If ruled ineligible as reserves, many could be called even before their call date in accordance with Dodd-Frank regulations, warns McAlinden. Overall, the market could see consolidation of various types of preferreds. And if new issues come with equity conversion triggers, this would compromise the reason for buying preferreds in the first place.
This all means that preferreds of large, diversified, name-brand firms may be the safest way to lock into attractive yields, according to experts.
Data Sources
The best free online source for preferred stock information is www.quantumonline.com. It provides valuable data-including latest credit rating, call dates, and tax status-and links to original prospectuses and the latest quotes. Flaherty & Crumrine manage a very helpful online guide as well: www.preferredstockguide.com.
Every week, Barron's publishes the only print table of 800 preferred prices and current yields. While it doesn't differentiate by preferred types, scanning these pages is very useful in getting a sense of the preferred market.
On the brokerage side, UBS Wealth Management Research generates regular reports on preferreds and maintains a comprehensive database on outstanding preferreds for clients of the bank.