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Income Investing

Don't Part With Preferred Stocks

Following big price run-ups, most income categories are no longer cheap. But neither are they overvalued.

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I don’t expect interest rates to move much before mid to late summer. When bond yields do bounce, you’ll barely notice. Yields on short-term debt might climb a quarter of a percentage point. Rates for long-term Treasury and corporate bonds and mortgage securities might work their way up by a half-point. For income investors, that is a benign outlook.

See Also: Kiplinger's Economic Outlook: Interest Rates

Yet my in-box is full of dire forecasts that 2015 will mark the beginning of a multiyear climb in rates to pre-2000 levels, when the benchmark 10-year Treasury paid more than 6%. The thinking is that with the U.S. economy improving, demand for credit will grow and the Federal Reserve will have to jack up rates to restrain inflation. I think this reasoning is unpersuasive and merely parrots the classic econ textbook line that rates take off when growth picks up.

But these aren’t old-school times. Yields in the U.S. are notably higher than those of other developed countries, and that attracts capital here. The break in oil prices means it’s unlikely that inflation will take off. And the economy is showing that it can expand by 3% without creating so much demand for credit that interest rates soar.

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For investors, however, things have changed. In the winter of 2013–14, steals and deals were abundant in such categories as municipal bonds, real estate investment trusts and preferred stocks. Today, though, following big price run-ups, most income categories are no longer cheap. But neither are they overvalued.

So what’s an income investor to do? Let’s ponder the question through the prism of one winning high-yield exchange-traded fund, iShares U.S. Preferred Stock (symbol PFF). Thanks to its juicy yield (5.6% today) and the appreciation of many of its holdings, the ETF returned 12.9% in 2014 through December 5. If you’re lucky enough to own PFF, it’s natural to ask whether you should sell now or stay put.

Because selling high is a basic tenet of successful investing, I wouldn’t criticize anyone for lightening up on the ETF. After all, a 13% gain is well above the long-term annual return for common stocks, and it’s not much less than the 14.5% return in 2014 of Standard & Poor’s 500-stock index.

Preferred math. Moreover, opportunities for further appreciation are limited. When I recently cross-referenced the ETF’s 331 holdings with the preferred-stock price listings at www.wsj.com, I found that a slew of the preferreds were at their 52-week highs or only pennies short. For example, PFF holds a series of Royal Bank of Scotland preferreds with interest coupons that range from 5.75% to 7.65%; each began 2014 selling at nearly $20 per share, meaning the issues were yielding 7.2% to 9.6%. But by early December, each preferred was trading for more than $24. To duplicate the ETF’s 2014 performance in 2015, the Royal Bank preferreds (and others like them) would have to hit $27 or $28. Unless interest rates plunge in the coming year—that’s a bet even I wouldn’t make—such a development is unlikely.

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However, I also wouldn’t object if you chose to hang on to the preferred ETF. First, the yield on your actual cost in PFF may be tough to match. If you bought the fund at the start of 2014 for about $37, your annual yield works out to 6.1%, not the 5.6% you would get if you bought today.

Second, a 5.6% current return isn’t bad in today’s low-yield world. Few mainstream income investments pay much more. The question you should ask yourself is whether 5.6% is fair compensation for the risks you take. Given decent economic growth and the low likelihood of interest rates jumping significantly, preferreds will probably hold their own in the coming year. So if you don’t want to sell PFF, you don’t have to.