Preferreds Come Off Strong Year
When we profiled preferred stocks March 9, we wrote that “the broad sell-off has presented opportunities for aggressive investors looking to bet on a rebound in financials.” As it turned out, the S&P U.S. Preferred Index, a capitalization-weighted index of 85 securities, bottomed on March 6 and returned nearly 169% for the remainder of 2009. For the year, the index returned 45.0%, versus a 26.5% gain for the S&P 500 Index.
Over longer periods, preferred stocks have generated much more modest returns. The Merrill Lynch Fixed Rate Preferred Index, which tracks traditional fixed-rate preferreds, has an annualized total return of 3.2% for the 10 years ended 2009. Last year the index returned 20.1%. The Merrill Lynch Capital Securities Index, which holds fixed-rate and hybrid preferreds and is similar to the S&P U.S. Preferred Index, has a 10-year annualized return of 6.0% and jumped 45.8% in 2009.
Income investors can appreciate the lofty yields of preferreds. The S&P U.S. Preferred Index yields about 7.4%, well above the 2.0% yield of the S&P 500 and 3.7% yield of the 10-year Treasury bond. The Merrill Lynch Fixed Rate Preferred Index yields about 7.2%, putting the spread relative to the 10-year Treasury at 3.5%, roughly in line with the average of 3.7% since 1997. The 15 preferreds we list in the table below average yields of 7.3%.
Importantly, preferred stock shareholders are not entitled to dividends until bondholders have been paid, making the shares highly sensitive to deterioration in a company’s creditworthiness.
Most preferred stocks are rated by Standard & Poor’s and Moody’s. So, for better or worse, a change in a firm’s credit rating may impact the price of its preferred stock. We recommend that investors focus on preferreds with investment-grade ratings, those rated at least BBB by S&P or Baa by Moody’s.
Most traditional, fixed-rate preferreds pay dividends that are taxed at just 15%, similar to qualified dividends on common stocks. However, hybrid preferreds’ dividends are typically treated as interest income and thus subject to higher tax rates. Among the 15 preferreds listed above, eight are considered eligible for the 15% tax rate.
Fund investors can tap into preferred stocks. Most funds are dominated by financial companies, which represent nearly 90% of the preferred-stock market. Closed-end funds are actively managed portfolios that trade like stocks and offer attractive yields. However, closed-end funds typically charge annual expenses of 1% to 2%. Also, a fund’s market price is set by supply and demand and may not correspond to the underlying value of its net asset value (NAV). For that reason, a fund may trade at a sizable premium or discount to its NAV. In addition, many closed-end funds use leverage (borrowed money), which can boost the yield but also make the shares more volatile.
Exchange-traded funds (ETFs) also trade like stocks, but usually without the premiums or discounts common to closed-end funds. ETFs investing in preferreds are built around passive indexes and have annual expense ratios of only 0.45% to 0.60%. iShares S&P U.S. Preferred Stock Index Fund ($37; PFF) mirrors the S&P index and is the largest preferred ETF based on assets. PowerShares Preferred Portfolio ($14; PGX) tracks the Merrill Lynch Fixed Rate Preferred Index.