Preferred Stocks Riskier Than You Think
The S&P U.S. Preferred Index, a capitalization-weighted index of 67 stocks, yields an eye-popping 15.7%. While many find it difficult to resist such a lofty payout, consider this: So far in 2009, the index has tumbled 40%, versus a 23% decline for the S&P 500 Index. Over the past year, the preferred index has plunged 60%.
There was a time when preferred stocks were considered “boring” investments, suitable for conservative investors seeking steady income with only moderate share-price volatility. This landscape changed dramatically in 2007, when financial firms began aggressively issuing preferred stock to raise capital.
The ensuing financial meltdown raised concerns about companies’ solvency and ability to pay dividends. Standard & Poor’s and Moody’s began downgrading credit ratings with greater frequency. In addition, increased tax-loss selling, coupled with the need for many closed-end funds to deleverage their portfolios, helped make 2008 the worst year ever for preferreds. To deleverage, many funds sold preferreds to raise cash.
The outlook brightened somewhat when the U.S. Treasury, as part of the Troubled Asset Relief Program (TARP), began buying preferred stocks. But recent weeks have seen a new wave of selling hit the stocks, reflecting the uncertain economic backdrop and weak fundamentals for the financial sector, which accounts for more than 80% of the S&P U.S. Preferred Index.
Is the worst behind preferred stocks? That’s impossible to say. Given the life-and-death issues facing many financials, owning preferred shares in such names is highly speculative. Still, the broad sell-off has presented opportunities for aggressive investors looking to bet on a rebound in financials — whenever that happens. Consider the following:
• Yield spreads on preferreds have reached historic levels relative to Treasury bonds. The spread between the yields of the Merrill Lynch Fixed Rate Preferred Index and the 10-year Treasury bond stands at roughly 12.9%, up from 8.3% at the end of 2008. Over the past five years, the spread has averaged about 2.3%.
• The average stock in the S&P U.S. Preferred Index trades at a 60% discount to its call price, with some discounts near 90%. Our list of 19 preferreds, which contains 10 financial names, trades at an average discount of 39%.
• The combination of TARP and President Obama’s stimulus plan should eventually improve the credit environment, boosting the odds of survival for many issuers.
Preferred stocks deliver high income — but nothing is guaranteed. Owners of preferred stocks are not entitled to dividends or principal repayments until bondholders have been paid, making them extremely sensitive to deterioration in a company’s creditworthiness. Typically, no dividends can be paid on a company’s common stock until dividends are paid on the preferred.
More than half of the preferreds listed in the table below are cumulative, with shareholders entitled to all past and present dividends. If a company halts payments on a cumulative preferred, it must pay all dividends “in arrears” before paying common-stock dividends.
Note that most preferreds have “call” features, meaning the stock may be repurchased by the issuer anytime after the callable date. Many preferreds have maturity dates (date when the principal amount or face value of the security will be returned to the shareholder) ranging from 20 to 50 years, and some have no predetermined maturity.
If you intend to purchase preferreds despite the risk, stick to issues with investment-grade credit ratings, those rated at least BBB by Standard & Poor’s or Baa by Moody’s. Spread your credit risk by holding several issues, ideally from different sectors.
For many investors, a fund holding a basket of preferreds might be a better choice than individual securities. The iShares S&P U.S. Preferred Stock Index Fund ($17; PFF) exchange-traded fund (ETF) mimics the S&P index. The fund, yielding roughly 15.7%, is nearly 78% in investment-grade securities. The fund’s annual expense ratio is 0.48%.
PowerShares Preferred Portfolio ($7; PGX), another notable ETF, tracks the Merrill Lynch Fixed Rate Preferred Securities Index. The fund holds 76 preferred stocks, with 75% in financials. Yielding 15.9%, the fund has a 0.50% expense ratio.