Low Rates Lock in Preferred Shares’ Allure

by Dan Burrows | May 7, 2013 1:55 pm

Low Rates Lock in Preferred Shares’ Allure

The big knock on preferred shares — especially perpetual preferred shares — is that they can get crushed when interest rates rise.

If that’s your biggest worry when it comes to these securities, go for it.

Rates ain’t rising anytime soon.

Why You Should Prefer Preferreds

Preferred shares often are referred to as “hybrids” because they give you equity ownership in a company — like a stock — but they pay dividends, usually quarterly, like a fixed income instrument.

Companies have to pay dividends on the preferred shares before they can make payouts on the common stock, so they have lots of incentive to keep the cash coming. Similarly, preferred shareholders come before common shareholders (but behind bondholders) if the company goes bankrupt and has to liquidate.

Additionally, if you hold what are called cumulative preferred shares, the company is on the hook for past payouts in the event that it gets into a cash crunch and has to suspend dividends for some period of time.

And then there are the high yields on preferred shares — an average of 6% — that look pretty great when benchmark 10-year Treasury notes are throwing off less than 2%.

Why You Shouldn’t

Of course, as with everything in investing and life, there’s no free lunch with these securities.

Preferred shareholders usually don’t get voting rights, for one thing. And these shares are often “callable,” meaning the company can buy back the stock at a predetermined price, usually after five years. Many classes of preferreds have maturities (like bonds), but perpetual preferreds don’t, meaning they can be called at any time.

The call and maturity features make the price on preferreds act like the par value of a bond, so it doesn’t move too much. If there’s big upside in the common shares, the preferred shareholders aren’t going to participate.

Fair enough: Preferred shares give holders a claim on a company’s future dividends — but not its future earnings growth.

Where Interest Rates Come In

Most importantly, preferred shareholders need to worry about interest-rate risk. Just as rising rates hurt bond prices, they hurt preferred stock prices too.

Banks and other financial firms are traditionally among the biggest issuers of preferred shares because they afford a third way (in addition to equity and debt) to meet capital requirements. And since most financial firms issue perpetual preferreds — which have no maturity date, can be called at anytime and have fixed yields — those are the preferred securities that have the greatest exposure to interest-rate risk.

Of which there is none right now.

No one pays more attention to interest-rate risk than bond investors. It’s one of the big three things that can blow them up, along with default and inflation. So when the biggest and best bond managers in the business — Jeff Gundlach at DoubleLine and Bill Gross at Pimco — say they’re not worried about rates rising anytime soon … well, preferred shareholders can probably rest easy.

That’s not to say preferreds — and especially bank-issued preferreds — won’t get clobbered in a market crash. Preferreds might have a lot in common with bonds, but that doesn’t actually make them bonds.

After all, preferreds were a horrible place to be in the last crash. The iShares S&P U.S. Preferred Stock Index (NYSE:PFF[1]) exchange-traded fund plunged far more than the broader market. And fears that the financial system would collapse caused the PowerShares Financial Preferred ETF (NYSE:PGF[2]) to utterly collapse. See the chart, data courtesy of S&P CapitalIQ, below:

Preferred CHART Low Rates Lock in Preferred Shares Allure[3]

From the beginning of 2008 to the market nadir of March 2009, the S&P 500 lost more than 50%. The iShares Preferred ETF fell 64%, while the Financial Preferreds dropped more than 73%. (Of course, shareholders in banks’ common stock did even worse. The SPDR S&P Bank ETF (NYSE:KBE[4]) dropped 79% over that same span.)

Today, it’s a different story. Solid corporate balance sheets and much improved capital positions in the financial sector mean the dividends should keep coming.

Bottom Line

With PFF yielding 5.8% and PGF throwing off 6.3%, investors looking for income should be able to comfortably hide out in preferreds for a good long while.

Yes, interest rates will have to rise eventually. But that’s a worry for another day.

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.

Endnotes:
  1. PFF: http://studio-5.financialcontent.com/investplace/quote?Symbol=PFF
  2. PGF: http://studio-5.financialcontent.com/investplace/quote?Symbol=PGF
  3. [Image]: http://investorplace.com/wp-content/uploads/2013/05/Preferred-CHART.jpg
  4. KBE: http://studio-5.financialcontent.com/investplace/quote?Symbol=KBE

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