In this period of elevated bond yields, many advisors view the classic 60/40 stock/bond portfolio as once again making sense.

Yet, in adding bonds to their client portfolios to reprise this traditional asset allocation, some generalist advisors may be overlooking the advantages of another fixed-income investment: preferred stocks.

Bond yields are still in an elevated period, but so are preferred yields. And preferred stocks are now in a growth spurt, delivering double-digit total returns since last fall.

As of March 20, the average annual dividend yield of preferred stocks in iShares Preferred Income Securities ETF (PFF), a bellwether for the category, was 6.39%—far higher than investment-grade bonds. For comparison, iShares iBoxx Investment Grade Bond ETF (LQD), a proxy for investment grade bonds, had a yield of 4.15%.

Currently, some preferred issues with lower credit ratings have yields as high as 8%. Many with excellent credit quality are paying around 6.5%.

Despite their rise in recent months, preferred stocks still have good potential for growth, as many issues are trading at a discount.

Given preferred stocks’ current total return, their diversifying effect on common stock portfolios and their usually qualified dividends, this is an advantageous time to add them to portfolios or increase allocations.

Discount From Fear
Preferred stocks are issued mainly by financial institutions. For banks, they’re regarded as equity on  balance sheets and thus count toward regulatory capital ratio requirements.

The current pricing discount comes from events that started a year ago, when preferred values fell precipitously after the failure of a few regional banks, beginning with Silicon Valley National Bank.

Though these failures were isolated cases of poor asset/liability management (largely related to impacts of higher interest rates), they nonetheless spurred investor fears about the solvency of regional banks nationwide and the stability of the overall banking sector.

There was no systemic sector risk. Yet, sustained by overblown media coverage, fears persisted, driving a roller coaster of volatility last year until October, when preferred stock prices declined to the lowest levels since 2000 and 2009.

Investor confidence has since increased, pushing the category up about 15% in total returns since the October low.

This recovery is relatively rapid historically. PFF is on track to reach its long-term past average price of $39 a share faster than it has after previous declines. At the current rate of growth, the increase in total return over the next couple years may be well into the double digits.

Favorable Factors
Factors currently enhancing preferred stock values include:

• A favorable yield-to-worst (YTW) metric. Average YTW, the result of a complex calculation quantifying the risks of worst-case scenarios, is now about 5.90%, compared with a 10-year average of 4.12%.

• Low call risk stemming from trading at a discount from par.   

• Widely anticipated interest rate cuts by the Federal Reserve (the Fed). Many big investment houses believe cuts will begin by summer, pushing down fixed-income yields, including those of new preferred issues. This would likely be a strong tailwind for existing issues with higher rates.

Evaluating individual preferred stock issues can be quite rigorous, so many generalist advisors may want to stick with funds.

Active Funds
They should look for actively managed funds because the passively managed variety brings exposure to indexes with issues that are negative yield-to-call, which active managers can avoid.

Of course, this comes at a cost. But investors are compensated for this expense with the higher total returns that can be produced by exploiting opportunities from market inefficiencies. Such inefficiencies can stem from the broader market’s failure to assess opaque credit characteristics or to discern the potential of as-yet unrated preferred issues.

In selecting funds, advisors should naturally avoid the trap of chasing yield. Some funds may appear inferior because they currently pay lower yields, but their total returns over time may be superior.

Here are some actively managed funds with good long-term track records:

• Nuveen Preferred Securities and Income (NPSAX), a mutual fund. Annual yield as of March 20: 5.62%. This fund comes in versions with and without a front-end load, which should be avoided to reduce expenses. Some brokerages may not carry the load-free version.

• Principal Spectrum Preferred and Capital Securities Income (PPSAX), a mutual fund. Annual yield: 4.96%. This fund also comes in versions with and without a front-end load. Some brokerages may not carry the load-free version.

• Principal Spectrum Preferred Securities ETF (PREF). Annual dividend yield: 4.58%.

• First Trust Institutional Preferred Securities ETF (FPEI). Annual dividend yield: 5.68%.

• First Trust Preferred Securities Income ETF (FPE). Annual dividend yield: 5.90%.

By focusing on credit quality, advisors can keep risk to a minimum. Advisors willing to do this homework can get the best long-term total returns for their clients.

Dave Sheaff Gilreath, is a co-founder and CIO, and Edward “JR” Humphreys II, a senior portfolio manager, at Sheaff Brock Investment Advisors and its institutional arm, Innovative Portfolios.