25 july 2019





STAY AWAY FROM PREFERRED STOCKS UNLESS YOU KNOW WHAT YOU'RE DOING



by Raul Elizalde

This article also appeared in forbes.com





Preferred stocks (“preferreds”) are a class of equities between common stocks and bonds. Like stocks, they pay a dividend that the company is not contractually obligated to pay like bonds, their dividends are typically fixed and expressed as a percentage rate. In a bankruptcy, preferred stocks are junior to bonds but senior to stocks.


Investors gravitate towards preferreds when they seek income and preservation of principal. While preferreds usually deliver on those goals, investors should be aware that there are serious limitations to what preferred stocks can accomplish for their portfolios.


One objection heard often is that a company would only issue preferred shares if they have trouble accessing other capital-raising options. It is generally cheaper for a company to issue a bond because interest payments on bonds are contractually guaranteed, and debt is senior to preferred stocks in a bankruptcy. Therefore, a corporate treasurer would only resort to issuing preferreds if the company wants to have the flexibility to suspend dividend payments, finds it difficult to find buyers for its debt, cannot find buyers for lower-dividend common stock, or would suffer a credit downgrade if additional debt obligations were added to its balance sheet. None of these alternatives is exactly reassuring.


Preferred stocks can also be less liquid than common stocks, not only because they are typically smaller issues but also because the main buyers and holders of preferreds are institutional investors. This is because a company that receives a dividend from another company can deduct most of that dividend from taxes – a benefit that is not available to individuals. Since preferred shares usually have large dividend rates, corporations like to buy them, which leaves a rather small portion of the original issue available for retail investing.


A far more negative trait is that most preferred shares are “callable”, which means that the issuer has the right to buy them back at a pre-set price. This could happen if the company finds that it can sell cheaper conventional debt or common stock with a lower dividend. This call feature virtually eliminates the chance of a rally, because as a issuer’s outlook improves it is likely to repurchase those high-dividend preferred shares at a fixed price. On the other hand, there is little to prevent preferreds from sinking if the issuer runs into difficulties and needs to cut dividends. The result is a non-symmetrical return pattern where the upside is capped but the downside is not.


Finally, individual preferred shares can be complicated. They can be “perpetual” or have a set maturity, they can be callable or not, their rate can be fixed or floating, they may or may not be “cumulative” – mandating missed dividends to be paid in arrears before common dividends are resumed – or have other features that individual investors are usually not prepared to analyze in detail and should leave instead to professional managers. The easiest way is to do this is to buy a fund dedicated to preferred stocks.


Here a strong note of caution is needed. Mutual funds that appear in screeners under the “preferred” category often include funds that are not fully invested in preferred stocks. Morningstar (a firm that started by researching mutual funds), for example, lists PPSAX (Principal Funds’ Preferred Securities Fund) in the “preferred stock” category, although according to the fund's latest "Schedule of Investments" 75% of its holdings are invested in bonds and just 21% in preferred stocks. This fund even appears in third place in the U.S. News & World Report’s list of “Best U.S. Preferred Stock Mutual Funds.”


Another option is to consider Exchange Traded Funds, or ETFs, that are actually fully invested in preferreds, such as PFF or PGX – currently the two largest by assets.


When looking at total return history the difference between their downside risk and upside potential, as discussed above, becomes clear.


A preferred stock ETF like PGX provided none of the stability of a fixed-income proxy during the financial crisis, losing as much as 65% from January 2008 while the S&P 500 fell “only” 48% in the same period. This large loss was undoubtedly due to the heavy tilt towards financial preferreds contained in the index tracked by PGX. During the crisis, the financial sector lost as much as 78% of its value.





In the years after the crisis, however, preferred stocks were a good source of largely predictable and steady returns, considerably outpacing a broad basket of bonds. But they lagged well behind common stocks (including financials), again because of the callability limitations placing a ceiling on how much they can rally.





In normal times investors can get stability of principal and predictable income with preferreds, with considerably less volatility than stocks and better returns than bonds. But expecting preferred stocks to also provide shelter against a serious market disruption can be a big mistake.


Before committing to this asset class, investors may want to do their homework, discuss their expectations with their financial advisors and understand what preferreds can and cannot do for their portfolios.