Are Preferred Stocks Right For You?

As an income-oriented investor, you could look to add high-yielding corporate bonds to your portfolio. Or maybe you could go on the hunt for stocks that pay fat dividends. Which would you prefer?

You just might prefer preferreds – preferred shares, that is.

Much like how the Osmonds were a little bit country, a little bit rock 'n' roll, preferred shares are a little bit equity, a little bit debt. Companies sell them to investors for all sorts of reasons, including their tax advantages and favorable treatment from regulators.

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Their blended nature might serve you well, as well. Most preferreds are issued by high-quality companies. The shares offer payments that easily beat common-stock dividend yields and are comparable to the yields of riskier high-yield bonds.

In most cases, investors can treat the preferred-stock distributions as dividends that qualify for tax-advantaged status, as opposed to interest income.

Moreover, preferreds' prices typically show a low correlation to both bonds and common stocks, making preferreds a handy diversification tool.

The first step in understanding preferred shares is understanding the capital structure of a company, which details the various ways it raised money to fund its operations. At the most basic level, companies either borrow money from banks and bondholders or they raise cash by selling stock.

Pay attention to the pecking order

In a worst-case scenario of bankruptcy, there's a clear pecking order of who gets paid back first. The lenders who are most "senior" get first dibs. Then, all the rest of the debt must be covered before the owner of a common share can get anything out of the company. Rare is the bankruptcy in which the common stock emerges with any value at all.

Preferred shares fall between debt and common equity. Their claims on a company come after claims of the debt holders but before claims of the owners of the common shares. That's what makes them preferred.

Because preferred shares are riskier than debt, they have lower ratings from the credit agencies. But because the companies that issue them are typically large and established, they're much more creditworthy than the ratings may imply.

"The one thing that slips under the radar for this category is it's a high-quality income solution," says Doug Baker, head of preferred securities at investment firm Nuveen.

His go-to example is JPMorgan. The credit agencies rate the bank's most senior bonds high on the investment-grade scale but place the preferred shares at the lowest tier of investment grade. "You don't have exposure to a borderline high-yield company. You really have exposure to that bellwether financial institution, JPMorgan," says Baker.

Banks, in fact, are heavy issuers of preferred shares, making the asset class far less diverse by sector than a broad stock market index.

Banks make up 36% of the ICE U.S. All Capital Securities index, which tracks the preferred-share market. Insurers account for another 22%. Other types of financial companies add another 7%, giving the group nearly two-thirds of the index. Roughly 19% is industrial companies and 16% is utilities.

Preferred shares, like common shares, are perpetual, meaning that they don't have a maturity date like bonds do. But many preferreds pay a fixed coupon rate for a set period, then reset their rate to the market.

Others have a variable rate that can reset each quarter. Preferreds carry some interest rate risk in that, like bonds, they can lose value as interest rates rise. If market rates are falling, there's a reinvestment risk of having to replace a higher-yielding preferred with a lesser-yielding one.

But the bigger hazard for individual investors buying preferred stock is call risk. Even though preferred stock doesn't mature, there are predetermined, preannounced dates on which a company can call, or buy back, the preferred shares from their investors. The company will pay the par value of the preferred shares, which is disclosed when the shares are first sold to investors.

Often, individual investors who see a juicy coupon rate will bid the price of the preferred shares above par – and then, when the company calls the shares, will lose money on their principal. In some cases, a preferred share's yield to call, a calculation that takes this into account, will be negative by a double-digit percentage.

Consider a preferred stock fund

Managers of preferred-share mutual or exchange-traded funds are far less likely to make this mistake. That and the diversification across multiple companies and industries make funds a better choice for most investors.

The biggest fund, and one of the oldest, is the iShares Preferred and Income Securities (PFF), a passive fund that follows an index that also includes hybrid securities, such as debt whose payments are considered interest, not dividends, and convertible debt, so named because it can be converted into common shares of the company.

The fund yields 6.4%. But its overall performance is middling, having finished in the top 20% of its category of U.S. preferred-stock funds just once in the past decade. (Yields, returns and other data are as of July 31 unless otherwise noted.)

Investors worried about high exposure to financial firms can look at the VanEck Preferred Securities ex Financials (PFXF). The fund's biggest holding on June 30, at 13% of assets, was convertible debt from Boeing.

Its yield of 6.5% is just outside the top 20% of preferred stock funds, while its 0.4% expense ratio is in the cheapest 20%. The fund ranked in the top half of its category in six of the past 10 calendar years; its total return over the past 12 months is 9.8%.

Actively managed funds that can buy preferred shares that are not listed on major exchanges have more options to try to beat the benchmark.

For investors who can tolerate a rockier ride, the Virtus InfraCap US Preferred Stock (PFFA) is a category standout. Its 9.2% yield is nearly two percentage points higher than any other preferred-share ETF in the Morningstar category. In the six full calendar years since its debut, the fund landed in the top 1% of its category four times – but in the bottom 10% the other two years.

The fund is leveraged, meaning that it uses borrowed funds (typically 20% to 30% of assets) to buy securities. That can goose returns – but it can also amplify losses. For instance, the fund sank 20.9% in 2022 but bounced back the next year with a 26.5% gain. It has returned 10.0% over the past 12 months. Borrowing costs help to push the fund's expense ratio to a category high of 2.52%.

Manager Jay Hatfield, a former investment banker in the energy sector, says he likes preferreds from companies with hard assets, but he isn't averse to owning financials: The fund currently has 37% of assets invested in financials; at other times, though, those holdings can drop to single digits.

This item first appeared in Kiplinger Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.

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