Give preferred stocks another look

The high yield behind this asset class earns it consideration as a core holding, but watch out for interest-rate movements.

By InvestorPlace Apr 21, 2014 2:56PM

© woraput/Vetta/Getty Images
Stock AnalystBy Daniel Putnam

Preferred stocks don't receive much attention, but maybe it's time that changed.

The asset class, which investors can access easily via the iShares U.S. Preferred Stock ETF (PFF), offers the compelling combination of competitive returns, low risk and an outstanding yield.

And yet, PFF has just $9 billion under management -- just a fraction of the $157 billion held in the SPDR S&P 500 ETF (SPY).

Based on a number of measures, it looks like investors are missing an opportunity.

The first benefit of preferred stocks is, of course, their yield. PFF currently offers an SEC yield of 5.8 percent, well above the 1.9 percent available on SPY.

Notably, that sizeable yield is also well ahead of the 4.5 percent to 4.8 percent dividend yields that investors can earn on index-linked high-yield bond ETFs.

Investors typically associate yields as high as PFF's with lower total return potential, but that's not the case here. The outstanding yield on iShares U.S. Preferred Stock ETF has contributed to its five-year average annual return of 16.5 percent, which is in the neighborhood of the 19.2 percent annualized gain for SPY.

The key consideration here is that PFF has achieved these returns with a lower level of risk: Its five-year beta is 0.7 and its three-year beta is just 0.42.

In this sense, the preferred stock ETF would have lagged the return of the broader market, but investors still would have earned outstanding returns for the risk.

How much does the bond market matter?

One knock on preferred stocks is that they're sensitive to interest-rate movements. Last spring, for instance, PFF was hit for a loss of 6.1 percent during the spike in bond yields that occurred from May 3 through June 24 -- far below the 2.2 percent loss for SPY in that same time frame.

This downturn might raise concerns of what might happen to preferred stocks if the long-awaited collapse in the bond market finally materializes.

Preferreds undoubtedly will take a hit anytime rates rise as violently as they did last spring. Still, there is an important reason why bond market performance might not be a major issue as long as yields increase in a controlled fashion: preferreds' yield spreads.

With a current yield advantage of 3.2 percentage points over Treasuries, the impact of a gradual rise in the 10-year -- say, from 2.6 percent to 3 percent -- doesn't have nearly as much of an effect on preferred stocks' yield spread as it would with lower-yielding assets.

This is likely to be a plus once the Fed starts raising short-term rates, since a move from near zero to 0.25 percent in the fed funds rate will take a bigger performance bite out of lower-yielding, high-quality bonds than it will from an asset class with yields near 6 percent.

If anything, an increase in bond yields might be a positive in that it would be a signal of better growth -- a plus for preferred stocks given their sensitivity to credit conditions.

Finally, the element of rate sensitivity in preferred stocks doesn’t necessarily have to be a headwind since bonds and stocks have demonstrated a high -- and increasing -- negative correlation in recent years. As long as this pattern holds, any major drop in stock prices is likely to be accompanied by a rally in bonds. This imbues preferred stocks with important defensive qualities, and it allows them to play the role traditionally filled by balanced fund ... although with a much higher yield.

The risk to this story is a market in which a sharp increase in bond yields is accompanied by a sudden downturn in stock prices -- a combination that occurred last spring. However, as long as the Federal Reserve manages its communications effectively, there’s a low probability that same scenario will repeat itself in the immediate future.

Low beta isn't necessarily a negative

This brings us to the next critique of preferred stocks: Since they don’t keep up with the major equity indices during bull markets, investors are leaving money on the table by owning funds such as PFF.

While that may be true, low beta soon might become a positive attribute given that SPY's current five-year average annualized return is a hefty 19.2 percent. With such strong returns in the books and valuations becoming stretched, a measure of defensiveness might not be a bad idea right now.

The past two weeks provide an illustration: From April 2 through April 14, SPY fell 3.1 percent while the iShares Russell 2000 ETF (IWM) was hit for a loss of 6.5 percent. In that same time frame, the PFF managed to generate a gain of 0.2 percent. And in 2008, PFF finished 13 percentage points ahead of the broader market, losing 24 percent versus the 37 percent downturn in SPY.

Bottom line

Preferred stocks won’t capture all of the market’s upside over the long term, but their risk-reward profile makes them a compelling option for yield-seeking investors -- especially if stocks begin to exhibit shakier performance in the months ahead.

More from InvestorPlace

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

Tags: PFF
Apr 22, 2014 8:20AM
I've owned PFF for several years now; it is an income investment, don't expect much growth. It is today worth just about exactly what I paid for it. However, I have received about 25% of the portfolio value in accumulated dividends, which come every month like clockwork regardless of what the "gloom and doom" crowd have been saying. Another few years and it will have paid for itself while the "chicken littles" out there sit on the sidelines waiting for the zombie apocalypse.
Apr 22, 2014 6:36AM
Again... it doesn't matter what type of stock it is, it was financially engineered to stratospheric value today but has NOTHING to back or substantiate that value. Every stock will fall as low as ZERO as we crash and crash is inevitable. Best to invest locally, at least you'll have a place to live when all else fails.  
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