If you plan to invest client assets in preferred stocks, be sure to put on your financial analyst's hat.

The preferred stock market is going through a major change. The banking system is in repair mode, and we are at the bottom of the interest rate cycle. Preferred stock values drop when interest rates rise. And in April, Moody's downgraded two banks and warned 15 others they are in danger of a downgrade because their balance sheets are loaded up with a dangerous level of debt. More than half of all preferred stocks are issued by banks. Eighty-five percent of all preferred stock is issued by financial companies.

Adam Kramer, co-manager of the Fidelity Strategic Dividend and Income Fund, says that 40% of the preferred stock market could disappear by 2015 because of new government regulations to shore up the banking system.

Under the Dodd-Frank act, as well as the international Basel III agreement, banks must terminate trust preferred stocks starting in 2013 and have them off the books by 2015. Trust preferred securities were considered in calculating Tier 1 bank capital by the regulators. Tier 1 capital is a measure of financial strength. It consists of common stocks, disclosed reserves, retained earnings and nonredeemable noncumulative preferred stocks.

Trust preferred stocks are hybrid securities, primarily issued by bank holding companies since 1993. Ranked lower in a liquidation proceeding than senior and subordinated debt, but higher than preferred stock, they became an attractive way for bank holding companies to boost reserves. Reason: They were considered "Tier 1 capital" by regulators-a measure of financial strength-and thus helped banks meet expansion goals. 

Besides cumulative trust preferred stocks, Tier 1 capital consisted of common stocks, disclosed reserves and retained earnings. With trust preferred stock arrangements, bank holding companies issued preferred stock through trusts, which then loaned the proceeds to the bank. The trust passes the loan interest to preferred stockholders in lieu of stock dividends.

Bankruptcy rules generally prohibit preferred stockholders of the trust from initiating bankruptcy.

Nevertheless, these arrangements gave the bank the best of both worlds. Because the IRS considers the loan a bank debt, the bank needn't pay corporate taxes on interest payments. Plus, the bank could temporarily stop paying dividends. Banks, however, were on the hook for the debt and possible accrued dividend payments. So Uncle Sam ordered them phased out and completely off the books by 2015.

By year-end 2008, more than 1,400 bank holding companies had $150 billion outstanding in trust preferred stock, according to a report by the Philadelphia Federal Reserve Bank. "New regulations put in place in the wake of the 2008 financial crisis may make thorough analysis more important than ever," Kramer says. "A wave of preferred stock redemptions by banks could take place as new rules impact trust preferred stock. That is why it is important to pay attention to what type of security it is, where it is in the capital structure and the price at which it trades."

Greg Phelps, lead manager of John Hancock's four closed-end preferred stock funds, says the change isn't going to detract from the appeal of preferred stocks for income. Banks are calling in their higher-yield trust preferred stocks and issuing lower-yielding tax-advantaged preferred stocks. Tax-advantaged preferred stock does qualify as a Tier 1 asset.

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%.

The fund is 57% invested in financials and 26% in utilities. About 15% is invested in the telecommunications and energy sectors. The largest holdings include Nexen Inc., U.S. Bancorp, MetLife, Barclays Bank, Goldman Sachs and Wells Fargo.

There are just a few open-end mutual funds that invest exclusively in preferred stocks. But there are a dozen closed-end preferred stock funds on the market. These funds use some leverage to boost yields and total return. Today, the asset coverage ratio of the closed-end funds is high, according to a Fitch Ratings report on closed-end fund leverage. Asset coverage is a test that determines a company's ability to cover debt obligations with its assets after all liabilities have been satisfied.

Cara Esser, an analyst with Morningstar Inc., Chicago, says that banks' new preferred issues should bode well for closed-end funds. Demand for high-quality preferred stocks is driving up prices.

"Closed-end fund managers have the flexibility in their management strategies compared to exchange-trade funds that mimic the preferred stocks market," she says. "It is likely they will include these new instruments in their portfolios. And many closed-end funds also hold preferred shares of utilities and telecommunications firms, mitigating some of the risks faced by the trust preferreds."

In this low-rate climate, money is pouring into income funds of all types. Net inflows into income and bond mutual funds totaled $166 billion year to date through May 2012, according to the Investment Company Institute, Washington, D.C.

Some advisors, however, question whether chasing high yields is worth the risk.

Preferred stocks, like bonds, are highly sensitive to changes in interest rates. Their prices may drop more than bonds' when interest rates rise.

"We recommend a small percentage in preferred stocks-not more than 20%," says Joseph S. Lucey, a Minneapolis investment advisor. "We combine preferred stocks with other types of bonds, as well as annuities when appropriate."
Lucey believes the financial system is still on precarious ground. So he invests in income funds that have about 15% of their holdings in preferred stocks.

William Donoghue, a Norwood, Mass.-based investment advisor, would rather invest in high-yield bonds and/or cash, based on a technical model he claims has outperformed the market.

"When you are at the bottom of an interest rate cycle, it is not if but when interest rates will rise that should be in the forefront of your mind," he says. "Preferred stocks are just stocks masquerading as bonds, and bonds are the wrong place to be when interest rates rise."

However, there are ways to reduce preferred stocks' risks and still get attractive income. Today, combining 50% preferred stocks with short duration U.S. government bonds delivers an annualized 3.25% yield, which is higher than the 30-year U.S. Treasury. But the mix is half as risky as the Barclays Aggregate Bond Index, according to Morningstar. Meanwhile, the total return on the 50-50 preferred-stock/short-term Treasury mix is 5.5% so far this year, ended in June.

Nuveen's Baker says that financial advisors comfortable hedging can place a put option on the S&P U.S. Preferred Index Fund, an exchange-traded fund, to hedge client preferred holdings. The cost of put options in down markets can be lowered by using a collar strategy, which is accomplished by holding shares of an underlying stock, purchasing a protective put and writing a covered call on that stock.

"It can be done, but it depends on the individual advisor," he stresses.