Why more investors should buy preferreds
Asset managers explain their favorite reasons to invest in this polarizing asset class.
Don Crumrine and Chad Conwell of asset management firm Flaherty & Crumrine explain that preferred shares offer strong income, as well as returns that are not highly correlated with common stock or other income-producing vehicles.
I was interested in speaking with you today because preferreds are not necessarily something that retail investors get much exposure to. You don't hear a lot about them in the financial media. Talk about how you use these, and what your fund's objective is.
Don Crumrine: The fund's objective certainly is high current income plus total return. The fund is an open-end structure, and preferreds are the highest-yield investment-grade asset class, which I think is why individual investors should consider them.
Preferreds continue to be attractively valued. The returns are not highly correlated with either common equity or debt securities. And the preferred market continues to be relatively inefficiently priced, which from our standpoint makes it fun to invest in. And we can add value, certainly, to the fund's returns over time.
Kate Stalter: Let's back up a little bit, for people who have not used preferreds before. Talk about what this specific vehicle is, and how people should be getting some exposure to these.
Chad Conwell: There are basically two different kinds of preferreds out there. There are preferreds that are listed and trading on the New York Stock Exchange. Retail investors can invest directly in those -- I'll talk about the issuers in a second.
And there are institutionally structured preferreds. These are preferreds that are structured more like corporate bonds, so they are sold in the over-the-counter market. The fund will invest and does invest in both sides of the market, so it lets a lot of retail investors, by investing in the fund, gain access to that institutional preferred market.
The issuers of preferreds are primarily from regulated industries, dominated, frankly, by financial issuers, mostly banks. Financial markets are about a 90% regulated market, just to give you some perspective. And regulated companies like using preferreds in their capital structure, because it allows them another source of capital in their use of leverage, thus providing better returns for their common shareholders.
Kate Stalter: For retail investors who are hearing or reading this interview, what's the advantage of preferreds over other ways that they can get income -- either through dividend-paying common stocks or through bonds? What's the advantage of a preferred?
Don Crumrine: The major advantage is that they are highest-yielding investment-grade investment asset class. Yields compared with Treasuries, for instance: They're probably 400 basis points higher, depending on what credit quality you pick.
But we're talking, by and large, investment-grade securities, or at least the issuers have investment-grade securities outstanding. And the incremental yield is pretty substantial in today's market.
Kate Stalter: Now you published a white paper called "Preferreds: What's Old Is New Again." That's an intriguing title. Tell us a little bit about that.
Chad Conwell: Sure. You know banks obviously suffered a great deal during the financial crisis. We don't need to rehash that. But as a result, those U.S. regulators in Congress, and international banking regulators through the Basel III process, have undergone really a transformation in how banks should structure their capital.
For the most part, those have been very good, positive things for preferred securities. Banks have to take on less -- are required to be less risky in their operations, for example. Banks have to increase the amount of common stock they hold in their capital. Since we're senior to common stock, that's a good thing.
And then what they did is they said that preferreds needed to be structured a little differently to qualify as Tier 1 capital, which is sort of the highest-quality capital in a bank's structure. And as a result, in the United States we are seeing the redemption of approximately a third of the preferred market, about $110 billion, which will ultimately be replaced maybe not dollar for dollar, but in concept with what is a traditional preferred stock, something that is a little more equity-like in its nature. In other words, it has a little more risk of default, which is what the regulators wanted to see in order to count it as equity.
This process is underway, as I said. The Federal Reserve just published rules a couple of months ago, I guess in early June, detailing sort of how they view the process. Those rules are still proposals, and will be implemented by the end of this year. But that triggered, really, a wave of redemptions out of the major US banks.
So we [US banks], to date, since that publication, have seen $27 billion of redemptions. You know that can hit investors who aren't paying attention fairly hard and they could own securities that are trading above the redemption price and take a negative hit to their price.
We've obviously been following these issues and trading around them, and we see it as an opportunity to invest the fund in new securities that are being issued as they start to be issued, and also to cash in on discrepancies in how securities are being priced today, in anticipation of their ultimate redemption.
Kate Stalter: You know, Chad, as you're speaking, it sounds like the kind of thing that for retail investors keeping up with this type of research would be very difficult. Maybe that leads us into what you would see as the advantages of using a fund like yours?
Don Crumrine: Sure, that's certainly true. You know, we have long experience in this asset class; we've been managing preferred portfolios at Flaherty & Crumrine for almost 30 years now. It's an asset class that individual investors really can't participate in a good portion of, because as Chad mentioned earlier, a good portion of the outstanding preferreds are issued in a structure, $1,000 par value -- an average trading size could be several million dollars.
Individual investors can't participate in this market very effectively. They're kind of constrained to the listed preferreds, which is a subset, a relatively small subset, of the market. So we certainly do have the expertise in the asset class, we certainly do trade in all sectors of the preferred market, and that's why the fund, I think, is the logical way for investors to invest in the asset class.
Kate Stalter: Do you see this fund used more by advisors putting their clients into it, or do retail investors purchase it for their own accounts? How do you see that working?
Chad Conwell: Well, I might let Destra comment more on the distribution end, but I think it's certainly being sold both ways, although primarily in the advisor account.
Kate Stalter: And do you have any sense of how you would see people using this alongside other equity and income investments within a portfolio? Where would this fit?
Don Crumrine: Well, it certainly fits on the fixed-income side. One point that I think is very important, which speaks to your question really, is the correlation of the asset class versus other, both equity and fixed-income asset classes.
And the correlations are relatively low, certainly relative to common equities, and that's an advantage for an individual investor. They can create an effectively diversified portfolio by including some portion of the portfolio in preferred securities.
The correlations are somewhat higher compared with fixed-income securities than they are with common equity, certainly, but even there, the correlation isn't perfect. It's correlation coefficient. I'm not sure that the folks that are listening to this are going to care too much, but nonetheless the correlation coefficients are below 0.6 for most other fixed income asset classes, and they're very low relative to common equities, for instance.
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A quote from this article "Since we're senior to common stock, that's a good thing.". In my experience, that doesn't mean a damn thing. If the common stock goes to zero in a bankruptcy, the preferred usually does too! I have been burned several times over the past few years in that respect (to the tune of MANY thousands of dollars), by Lehman, Fedders, and Delphi, all highly respected companies! I, long ago decided to stop investing in preferreds. If the preferred is going the same way down as the common stock of a company, I might as well invest in the common with its usually higher return AND possible accretion in value.
Another thing that "gets my goat" is the way that these companies interpret the rules for the call of their preferreds. Just about any "excuse" will do, even if the preferred is "call protected" at the time, i.e., change of ownership, force majeure, a statement by the Federal reserve, etc. This seems to especially happen if the preferred is selling at a significant premium, and down goes my premium!!!
Preferred stocks equal a big "BLAH" from me!
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