Plus, it is noncumulative, which means the bank holding company can suspend dividend payments without having to pay them back later on. The issuer is eligible for corporate dividend-received deductions, and investors can receive the 15% qualified dividend tax on income.
The strengthening of bank capital standards is considered a positive development for preferred stockholders.
"If you look at bank balance sheets, the amount of capital for common stock and retained earnings has grown substantially," says Douglas Baker, manager of the Nuveen Preferred Securities Fund, an open-end mutual fund that yielded 6% at this writing. "It is much higher than it was before the financial crisis. A more stable balance sheet benefits preferred stock and unsecured debtholders."
Others are not so sure about bank risk-based capital in the wake of J.P. Morgan's recent $2 billion-plus trading loss. "The J.P. Morgan case is seen by many as a warning shot-notice that incentives and practices at big financial institutions can still, despite the lessons of the financial crisis, produce a toxic mix," says Franklin Allen, finance professor at the Wharton School in Philadelphia. "The lesson is how difficult it is to control risk. If a bank can lose $2 billion, can it lose $20 billion? What if several banks had big trouble at the same time?"
On the interest rate risk side, money managers say rising interest rates should not be a factor today. Phelps, of John Hancock, says that the economic environment favors preferred stocks. It will take a 100- to 150-basis-point rise in interest rates to hurt preferred stock prices because they trade at a historically high spread to bonds.
"The Federal Reserve pledged to keep interest rates at very low levels until 2014," he says. "An environment that is characterized by steady and low rates has historically been beneficial to preferred security."
Although new issues yield less than older ones, Baker, of Nuveen, says he can pick up yield in straight preferred stocks. If he has a choice between two issuers with the same investment-grade rating, he invests in the higher-yielding issue. For example, Wells Fargo has the same rating as PNC. He also captures higher yields from utilities and REITs that issue trust preferreds, which are not subject to the bank regulators' standards.
"Credit research becomes important in the ability to select among different preferred structures such as trust preferred, enhanced trust preferred and preferred stocks," he says.
The Nuveen Preferred Securities fund is 98% invested in financial preferred stocks. These stocks are split almost evenly between preferred stock and trust preferreds that have not yet been called. The rest is invested in utilities. Baker has some exposure to foreign preferred issuers, which, he says, have strong fundamentals. Most of his funds hold investment-grade paper. But lower-rated paper, case by case, is also attractive. The largest holdings include J.P. Morgan, Wells Fargo, MetLife, Assured Guaranty and Liberty Mutual.
"We believe that [below-investment-grade] will provide a more compelling risk-adjusted return profile versus higher-rated securities," he says. "Lower-rated securities are often overlooked by retail and institutional investors with investment-grade-only mandates."
Phelps, of John Hancock, is picking up yields in preferreds selling at a discount to par value, as well as preferred issues by foreign banks with U.S. branches. The John Hancock Preferred Income Fund, a closed-end fund with about 30% leverage, yields more than 7%.