The chorus heard around the capital markets these days has actually been the same for years: it’s difficult to find yield in the marketplace. You’ve heard it before, and may even know the challenges firsthand as you manage your investment portfolio.
Many investors have been turning to preferred stocks as an alternative to bonds in this challenging environment, with their focus turned squarely on yield. The S&P U.S. Preferred Stock Index has a yield of approximately 6%, which pummels yield on corporate bonds (~3%), U.S. Treasuries (10-year at ~1.6%), and the S&P 500 (~2%).
When you look solely at yield, choosing preferred stocks makes logical sense. If you’re choosing between 6% versus 1.6% for yield on an investment, you’d choose 6% all day! The problem with that logic is that there is more to the story than just yield. Many investors are forgetting about some of the risks and limitations that come with investing in preferred securities, which we’ll review here.
Understanding Preferred Stocks – Pros, Cons, Risks, and Limitations
Preferred stocks are essentially a hybrid of stocks and bonds. They combine features of debt, in that they pay fixed dividends and are callable, and stocks in that they have the potential to appreciate in price (though less so than common stocks).
There are key differences, however. There is no dividend guarantee and no fixed maturity date with preferred stocks, and if interest rates go down a preferred stock issuer can call the shares at par – which may mean losses for investors who bought shares at a premium – and reissue them at lower rates. Another issue investors need to be cautious of is that over-investing in preferred stocks could mean over-concentrating your portfolio, and with that putting it at more risk. Currently, about four-fifths of preferred securities issued come from banks and other financial companies. If the sector were to take another hit, the losses could be severe.
On the equity side, owners of preferred stock (unlike holders of common stock), do not participate fully in the upside if a company grows more profitable. Again, the return on preferred stocks is a mainly a function of the dividend yield, which can be either fixed or floating.
Nevertheless, the high yield alone has attracted a lot of new capital, and it follows that the preferred stock segment may be overheating. Through August, the iShares U.S. Preferred Stock exchange-traded fund has attracted $2.2 billion of fresh money, and much of the solid returns for preferred stocks on the year owe to price changes versus increases to the fixed dividend – a worrisome sign.
Corporations are taking note of the increased demand for preferred shares. Through mid-year, there were more than $30 billion of new preferred stock issues, and the feedback loop fed into demand and led to a sharp rise in share prices for many. As a result, many preferred stocks in this marketplace are trading at a premium, which leaves an investor vulnerable to losses in the event they are called.
Bottom Line for Investors
We’re not arguing against preferred stocks. For some investors they can make sense as part of an overall portfolio, and their yield can be a helpful tool for creating income. What we’re merely observing is that the market for preferred stocks has gained a lot of popularity quickly, and that can be a dangerous quality for any type of asset. It’s important for investors to know what they’re buying and what the risks are.
Disclosure