Are Preferred Stocks An Alternative To Safe Bonds? by Larry Swedroe

Low interest rates mean that investors can no longer generate the income they need (and were used to). This dilemma has triggered a search for higher-yielding alternative forms of fixed income investing. Those investors who choose preferred stocks must understand the hidden and obvious risks.

With nearly $18 billion in assets, the iShares U.S. Preferred Stock Fund (PFF) is by far the leading ETF with exposure to preferred stocks. Its current 12-month yield is 5.62%, which explains investor interest in the fund. The question I will examine is the following: What role, if any, should preferred stocks play in your portfolio? I begin with a brief description.

Preferred Stocks
Image source: Wikimedia Commons

Important details about preferred stocks

Preferred stocks are technically equity investments, meaning investors who own these securities rank behind debt-holders in the lineup of credit priority. While preferred shareholders receive preference over common equity holders in the case of a bankruptcy, all the debt-holders would have to be paid off before any payment would be made to the preferred shareholders. And, unlike equity shareholders who benefit from any growth in the value of a company, the return on preferred stocks is primarily a function of the dividend yield, which can be either fixed or floating.

[drizzle]Preferred stocks are either perpetual (they have no maturity) or long term (with a maturity typically between 30 and 50 years). Preferred stock issues with a stated maturity of 50 years may include an issuer option to extend it for an additional 19 years. Investors who are considering the purchase of a long-term preferred stock should ask themselves: I purchase a bond from the same firm paying the same interest rate with a 69-year maturity?

The answer should be, “No!”

Why? Because the maturity is too distant, well beyond the investment horizon of most people. The very long-term maturity of preferred stocks also creates a problem. Among fixed income investments, the longer maturities have the poorest risk/reward characteristics (the lowest return for a given level of risk). The long maturity typical of preferred stocks is not the only problem with these securities. They typically also carry a call provision.

Asymmetric risk

A call provision gives the issuer the right, but not obligation, to prepay the debt. U.S. government debt (as well as all non-callable debt instruments) has no call provision, so it has what is called symmetric price risk. A 1% rise or fall in interest rates will result in roughly the same change in the price of the bond (but in the opposite direction) for each unit of duration. This is not the case with callable preferred stocks. The reason is that if rates rise, the price of the preferred stock will fall; if rates fall, and if the issuer is entitled to do so, the preferred stock will be called in and likely replaced by a new preferred-stock issue at a lower rate, conventional (and cheaper) debt or perhaps even equity. Thus, you have asymmetric risk – you get the risk of a long-duration product when rates rise, but the call feature puts a lid on returns if rates fall.

Another risk associated with buying callable preferred stocks is that the call feature isn’t related only to interest-rate risk, but also to the risk of changes in the company’s credit rating. A company that has low-rated credit and a high-yielding preferred stock issue likely will call in the preferred stock if its credit status improves. It would then replace the preferred stock with a then higher-rated conventional corporate bond (and take advantage of the tax deductibility of coupon payments). Of course, if the company’s credit deteriorates, it will not call in the preferred stock (but the price of the preferred stock will fall due to the deteriorated credit). Again, this results in asymmetric risk for the investor.

There is yet another critical point to cover. Longer-term maturities with fixed yields do provide a hedge against deflationary environments. However, the problem with longer-maturity preferred stocks is that the call feature negates the benefits of the longer maturity in a falling rate environment. Thus, the holder fails to benefit from the rise in price that would occur with a non-callable, fixed-rate security in a falling rate setting. If the issuer isn’t able to call in its preferred stock, it is likely because of a deteriorating credit rating, putting the investor’s principal at risk. Given that preferred issues are often from companies with weaker credit ratings, and those distressed companies are the very ones most likely to default in deflationary environments, the benefit of the high-yielding longer maturity is unlikely to be realized by investors holding these callable instruments.

Read the full article here.

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