Since the end of the Great Recession in 2009, expectations for higher interest rates have been dashed. Many observers divined runaway inflation and soaring interest rates within the decade. That type of climate would argue against holding preferred stocks. Instead, rates rose only marginally and now appear to be headed lower again in response to a slowing economy.
In an environment of declining rates and low absolute returns, preferred shares can offer a compelling option for investors seeking relatively high income and some capital preservation. Let’s take a look at what they are and why they might be appealing.
Unfamiliar to many investors, preferred stocks are a centaur security: half bond and half stock. Also known as “preference shares” in Europe, this class of security gained in popularity during the 19th century in raising capital for the expansion of U.S. railroads. Today, about three-fourths of all outstanding preferreds are issued by financial institutions, with utilities, industrials, and REITs making up the balance.
Unlike their early predecessors, most preferred stocks today are actually “trust preferred securities,” essentially a clever way to disguise debt as quasi-equity. Banks, for example, can issue bonds which are placed into a special purpose trust. The trust then issues shares to the public, representing a fractional ownership in the trust (and the underlying bonds). These newly created preferred shares then trade on one of the U.S. stock markets. The interest on the bonds is paid into the trust and then passed along to investors as a preferred dividend.
Preferred shares differ from common stocks in several important respects. Typically, they do not carry voting rights. Dividends are stated at the time of issue and cannot be changed unless the company is in financial distress (note that some issues may carry an adjustable rate). And preferred stocks are issued with a face value (typically $25 although other amounts occur), at which the issuer can usually redeem the shares or which must be paid out at the stated maturity date.
Preferred shareholders rank in the middle of the pack in the event of a liquidation: behind bondholders, but ahead of common stockholders. Thus their general risk level falls somewhere in between. Many issues also carry ratings from S&P or Moody’s.
Investors must understand whether the preferred is “cumulative.” If the issuer is experiencing sufficient distress to curtail the preferred dividend, a cumulative issue requires that all missed payments be made up before common shareholders receive any distributions (assuming the company does not declare bankruptcy).
Due to their bond-like qualities, preferred shares tend to underperform in a rising interest rate environment. Although some aspect of their prices are determined by the general performance of the issuer (like common stocks), the lion’s share of value for non-distressed shares is a function of rates and the relative yields of other instruments (like government bonds). If rates are now falling, this asset class could be appealing. In addition, many issues pay dividends that are “qualified,” meaning they are taxed at the lower capital gains rate.
Research here is sparse, making it difficult to assess the appropriateness of potential candidates for a portfolio. For most, a mutual fund or ETF is the best vehicle to ride if you are interested in gaining exposure, and many of the major fund companies have good offerings. Be sure to keep the expenses low (50 basis points or less) and avoid closed-end funds that use leverage at first, unless you have a thorough understanding of how they work.
Christopher A. Hopkins, CFA
Vice President and portfolio manager
Barnett & Company