There are many references to equality in U.S. history, but when it comes to being a shareholder in a corporation, some shareholders are more equal than others.
This reality stems from the issuance of capital stock. Preferred stock shareholders, like common stock owners, have a partial ownership right in a corporation. But preferred stock shareholders lack voting rights, and they also get a slight kicker: If the corporation is able to pay, they will receive a fixed dividend before common stock owners receive theirs. In the event the corporation goes bankrupt, preferred shareholders have a greater claim on assets than common stock owners.
To refine this category more, there are four types of preferred stock:
- Cumulative preferred stock
- Non-cumulative preferred stock
- Participating preferred stock
- Convertible preferred stock
Preferreds are hybrid securities. They have characteristics of bonds (behind bondholder to get paid) and stocks (they are a fixed obligation), but many of the deficiencies of both: they have no income appreciation potential and lack the contractual protection bondholders receive.
Since this stock classification has special appeal, mutual funds and ETFs were created to offer investors a different twist on corporate ownership and the chance for appreciation and the pursuit of better performance during volatile market conditions.
Yet while many shareholders think that corporate bankruptcies are a remote possibility, the recent IPO from General Motors shows that investors who wanted to participate in the IPO also sought additional guarantees that the re-born company would remain solvent.
As a result, GM issued 60 million shares of the Series B preferred stock at a public offering price of $50 per share. The Fitch rating firm tagged the Series B preferred with a ‘B-‘ rating because of its relatively low position in the hierarchy of GM’s capital structure. The Series B preferred stock ranking is subordinate to both the company’s debt, as well as its existing Series A preferred stock.
While that shows how preferred stock ranks in the capital hierarchy, preferreds also have different price performance characteristics. Specifically, the price performance of preferred securities looks more like bonds compared to equities or real estate. Unlike common stock, preferreds do not offer the opportunity for income appreciation. That’s why some fund managers make the argument that preferreds offer the opportunity for enhanced portfolio diversification.
A Fatal Attraction?
In a zero-yield environment, investors are attracted to preferreds, but that alone is not sufficient reason to buy them. Most fund managers buy preferreds if they can buy them at a discount, and if the long-term fundamentals of the company are solid. If inflation remains low, a manager can collect income without taking long-term risk.
If an issuer has low credit risk, investors should look at extension risk, or the danger that they will have to hold the preferred for an extended period of time waiting for the credit quality of the company to improve. That could take a long time without earning any return.
But as yields rise, there will be more competition for preferreds. As inflation rises, preferreds do not offer any protection because they do not generate income. Since they are basically a perpetual bond, they will perform poorly in an inflationary, high-interest-rate environment. As a result, preferreds should not be considered a buy-and-hold investment.
But the attraction of high yields is very powerful. That’s why professional fund managers have a role in evaluating and managing a preferred securities portfolio.
Today, investors can access this investment through ETFs and mutual funds. Here are short profiles of five top preferred securities ETFs and five mutual funds.
Convertible and Preferred ETFs
iShares S&P U.S. Preferred Stock ETF (NYSE: PFF)
Assets: $6 billion
Expenses: 0.48%
Yield: 7.32%
Top Holdings: Financial (100%).
PowerShares Financial Preferred ETF (NYSE: PGF)
Assets: $1.8 billion
Expenses: 0.65%
Yield: 7.11%
Top Holdings: Financial (100%).
PowerShares Preferred ETF (NYSE: PGX)
Assets: $1.4 billion
Expenses: 0.50%
Yield: 7.05%
Top Holdings: Financial services (80%), utilities (20%)
DR Barclays Capital Convertibles ETF (NYSE: CWB)
Assets: $457 million
Expenses: 0.40%
Yield: 4.55%
Top Holdings: Financial services (58%), consumer goods (41%).
SPDR Wells Fargo Preferred Stock ETF (NYSE: PSK)
Assets: $88 million
Expenses: 0.45%
Yield: 6.54%
Top Holdings: Financial services (100%).
Convertible and Preferred Mutual Funds
Advent Claymore Convertible Securities & Income (NYSE: AVK)
Manager: F. Barry Nelson
Investment Objective: The fund seeks total return from current income and capital appreciation through investment in convertible and nonconvertible debt securities.
Assets: $714 million
Expenses: 1.95%
Top Holdings: Financial services (63%), utilities (31%).
Advent/Claymore Global Convertible Securities and Income (NYSE: AGC)
Managers: Paul Latronica , A. Hartwell Woodson, Tracy Maitland
Investment Objective: The fund seeks total return through investments in global convertible and non convertible securities and utilizing and option writing strategy
Assets: $465 million
Expenses: 2.34%
Top Holdings: Financial services (60%), utilities (28%), consumer services (5%).
Bancroft Fund (AMEX: BCV)
Managers: Thomas H. Dinsmore
Investment Objective: The fund seeks current income and capital appreciation through investment in convertible securities
Assets: $100 million
Expenses: 1.30%
Top Holdings: Consumer goods (57%), industrial materials (42%).
Calamos Convertible & High Income Fund (NYSE: CHY)
Managers: John Calamos, Sr., Nick Calamos, Jr., Steve Klouda, Jeff Scudieri
Investment Objective: The fund seeks current income and capital appreciation through investment in convertible securities and below investment grade non convertible debt securities
Assets: $920 million
Expenses: 3.10%
Top Holdings: Health care (30%), financial services (25%), consumer goods (14%), industrial materials (31%).
Ellsworth Convertible Growth and Income Fund (AMEX: ECF)
Managers: Thomas H. Dinsmore
Investment Objective: The fund seeks current income and capital appreciation through investment in convertible securities
Assets: $94 million
Expenses: 1.20%
Top Holdings: Media (26%), telecommunications (51%), health care (23%).
Gabelli Convertible and Income Securities Fund (NYSE: GCV)
Managers: Mario Gabelli
Investment Objective: The fund seeks high total return of current income and capital appreciation through investment in convertible securities
Assets: $80 million
Expenses: 2.01%
Top Holdings: Software (5%), hardware (16%), telecommunications (8%), health care (10%), consumer services (6%), financial services (16%), consumer goods (12%), industrial materials (8%), energy (9%), utilities (11%).
