As stock markets chop around and Treasury yields dip to dismaying lows, investors continue to search high and low for income. They've even been spotted sending money to mutual funds investing in the utility sector, a corner of the market not popular for many moons.
One often-overlooked tool now in the spotlight is preferred stock. And no wonder. The hybrid securities-technically stocks, they act like bonds -now boast yields in the 7% range. "With 10-year Treasuries earning 2.5% we're seeing a grand interest in these income-producing securities," said Tom Roseen, head of research at fund tracker Lipper.
There are many different types of structures of preferred stock, which makes investing in them an exercise in reading fine print.
Still, most share a few traits. Preferred stocks rank higher in the capital structure than common stock, but just below bonds. Like bonds, they pay holders a fixed-income. The dividends they pay are often higher than those of the company's common stock. And if the company has to cut back dividends in tough times, when they resume payment, they must pay preferred shareholders first.
Some types of preferred shares, called "cumulative," pay shareholders the missed dividends.
And if the company goes bankrupt, preferred shareholders are in line behind bondholders to get paid.
These securities might come with call provisions, trade like bonds and represent 7% of the corporate bond market. So it's not surprising that in spite of the name, investors generally view them as part of their fixed-income portfolio.
Preferred stocks can trace their history in the U.S. back to the 1830s, when they were issued by the railroads. They have waxed and waned with the economy over the years. "Now they're getting popular because people want the income," says Kenneth Winans, president, founder and portfolio manager at Winans International, an investment management company specializing in preferred stocks and real estate. "They're less convinced the housing market or equity market is coming back any time soon," Winans says.
Winans has written two books on the subject, and has tracked the long-term performance of preferred stocks. Throughout the 20th century, they beat bonds but lagged common stocks. But narrow the time horizon to the troubled period since 2000 and preferred stocks led the pack with gains of 9.1% while common stocks eked out a mere 1.2%, and corporate bonds rose 6.9%.
He notes that preferred stocks also have been half as volatile as common stock in the turbulent last decade. Since 2000, common stocks have lost value 40% of the time, while preferred stocks slid 20% of the time.
Unfortunately, reaping those gains and portfolio stability is not as simple as buying a mutual fund. Preferred stocks occupy an odd corner of the market, one not much visited by mutual funds.
Only four funds tracked by Lipper have the word "preferred" in their name. There are also four ETFs tracking preferred stocks, one of which covers the Canadian market. And those performances have been less than stellar of late, surprising given the impressive yields.
The iShares S&P US Preferred Stock Index Fund, a decent proxy for the market, has lost 2.8% in the 12 months to mid-October, according to Lipper. In the same period, the Principal Preferred Securities Fund, a specialist fund, slid from 1.3% to 2.4%, depending on the share class.
But equity income funds use preferred stocks too, and Lipper lumps the eight specialists in with them. Its Flexible Income Funds category does not inspire: the group has shed 0.5% in the 12 months to mid-October. Yet spooked investors don't seem to care. The group took in a net $3.6 billion last year, and $1.7 billion this year through September 30.
There is at least one obvious reason for the lackluster returns: about 70% of the preferred stock universe is made up of financial services companies, a sector that has struggled off-and-on since the crisis began in 2008, and got clobbered this summer amidst the European debt crisis.
Winans doesn't like financials, citing his other specialty, housing. "No one knows where the bottom is on the loan portfolios when it comes to housing. Stepping into a long-term investment in a bank, I'm not comfortable with that. It's like catching a falling knife."
Other preferred specialists disagree. Doug Baker, head of the preferred securities team at Nuveen Asset Management, and head manager of the company's Preferred Securities Fund, thinks financial services look "incredibly compelling." He noted that because many preferred stocks are priced at $25 par value, they appeal to retail investors. (Many others are priced at $1,000 par value and tend to be bought by institutions.)
Retail investors fled financial services after a summer of relentless headlines about the crisis in Europe. His funds now have "meaningful exposure to financial services," across industries, including insurers and banks, domestic and international, "because after a decent amount of selling in the space, that's where we think the opportunity is. I don't think that means it has to be a risky investment," he added.
He says the key is choosing carefully from among the various structures of preferred stock.
He noted that some, including trust preferred securities, have defensive qualities. These include being cumulative, or having other features to encourage the company not to skip paying dividends, including giving investors benefits such as the right to elect members of the board of directors. He said the decision-making process of investing in preferred securities is more complex than buying the common stock of an issuer. With preferred stock, if a client likes the company, there are several layers of securities he can choose to match his level of conviction.
Baker warns advisors that mutual funds specializing in preferred securities by default must have hefty exposure to financial services-at least 50% of the portfolio, simply for the sake of liquidity. Although the sector has some utilities, some REITs, smaller homebuilders and automakers, it is uniquely concentrated in financials. "If that's not your risk appetite, maybe look at an asset class further up the capital structure like senior bonds," he said, noting that this asset class is hybrid, and the performance often falls between stocks and bonds.
Brian Rehling, chief fixed-income strategist of Wells Fargo Advisors also sees "great opportunities" in the preferred market.
He notes the high level of exposure to financials has hurt prices, but notes that the securities continue to pay handsomely. "They should continue to pay those high yields and are a good opportunity for finding some income, and they should continue to be paid in the majority of names through any number of scenarios," he says. He warned there may be volatility in the short term. But he sees the U.S. economy slowly recovering and believes the European debt crisis will be heading toward a resolution in the next several months. And preferreds should perform well in that environment, he says.
He added that even if interest rates rise moderately, 1% to 2% in the next couple of years, he doesn't expect it to affect prices. (Winans notes that his research shows that preferred stocks perform badly in inflationary environments, such as 1965-1982, when the average annual return was 1.4%.) Indeed, Rehling thinks if things improve, spreads will tighten and the income streams will be increasingly attractive to investors.
If You Must Do It Yourself
The good news is smaller managers have an advantage in this market because it is relatively thinly traded. "We have $150 million in assets under management, and we can comfortably maneuver in this universe," says Winans. "If you have $1 billion in assets under management, that's very tough to do."
Some of his top picks come from the REIT sector. He likes Kimco's preferred stock from the F or G series, as well as any of the 20 series from Public Storage. Another favorite is DTE Energy, a utility formerly known as Detroit Edison, either A or C series.
Rehling also favors the REIT space, recommending Public Storage's R series, as well as Kimco's H series and Vornado's J series. He also likes senior notes from Goldman Sach and TDJ.
But remember Winan's tip for advisors and others building their own mousetrap: check under the hood. "A lot of people just go after what's paying the highest yield and neglect to check why that yield is as high as it is," he says.
There are a few websites that can help advisors do just that, such as epreferreds.com. And Winan is working with Thomson Reuters on a software package that allows investors to analyze the price history of a preferred stock to determine if it is overvalued or undervalued. It will be available in November.
His own Winans International Preferred Stock Index, which tracks preferred shares since 1900, is available by subscription from globalfinancialdata.com. And in Morningstar's Principia Pro software there are tools that allow advisors to carve out preferred stocks from funds. "They're going to be really shocked that there are so few choices available," he says.