I can’t even begin to tell you how high I am on preferred stocks — if you’ve been reading my column for the past several years, you know that there’s great opportunity in this asset class.
Let’s review what preferred stocks are and why they are so great at this point in the market’s history. And we’ll look at my favorite ETF for holding preferred stocks, the iShares U.S. Preferred Stock ETF (NYSEARCA:PFF).
Preferred stocks are a stock-bond hybrid. Companies issue preferred stock in order to raise capital without diluting existing shareholders, and without placing more debt onto the company to compete with other bondholders.
Preferred stocks usually has no voting rights, but in exchange for this, and for having the privilege of being behind bondholders but ahead of common stockholders to recover their investment in case of liquidation, preferred holders earn very generous dividends. They usually run from 5.5% to 9%.
These dividends have another advantage. They cannot be cut or suspended unless the common stock dividends are cut first. Furthermore, most but not all preferred issues are “cumulative.” So if a preferred dividend is cut, it continues to accrue and all the accruals have to be paid out once those dividends resume.
Preferred shares trade like stocks on the exchanges, and are more liquid than bonds. They tend to trade in fairly tight ranges, so they behave a bit more like bonds in that regard.
Personally, I think that there is so little additional risk with preferred stocks compared to bonds, and pay so much more in dividends that they are hands-down a better investment for those looking for yield — i.e. retirees.
Now, you can invest in individual preferred stocks, and there are plenty of them to choose from. Almost all are going to provide a high degree of safety.
There are only three things you need to really look closely at.
- Whether the underlying company is solvent enough to stay in business, and pay both common and preferred dividends. A company can literally not be growing EPS at all, but if it is a cash flow machine and has a preferred stock issue, it is almost always a better choice to go with preferred stocks.
- Make sure you don’t overpay. Most preferred stocks are issued at $25 per share. You don’t want to pay more than 5%-6% more than that, since you are risking capital loss, especially if the call date for the issue is approaching or past.
- If interest rates rise significantly, then people will move away from preferred and into higher yield bonds, but that’s a ways off.
The best way to buy preferred stocks is via an ETF.
My favorite ETF for preferred stocks is PFF. Its yield is 6.2%, and only 0.47% — $47 for every $10,000 invested — gets sucked up by expenses. PFF has 312 holdings so you have exceptional diversification. Nearly 40% of the holdings are in banks, 16% in diversified financials, 14% in real estate, 10% in insurance, and the rest is across different sectors.
There are a few other choices, but they are all very heavily weighted in financials — even more than PFF, and while they are worth a look, I can’t really suggest them because of the lack of sector diversification.
So I would buy PFF, sit back, collect the yield, and mine the fund fact sheet to find individual issues you might want to investigate further.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. He has 20 years’ experience in the stock market, and has written more than 1,200 articles on investing. He is the Manager of the forthcoming Liberty Portfolio. He can be reached at TheLibertyPortfolio@gmail.com. As of this writing, he owned shares of PFF.