Don't Overlook Preferred Stocks

If you ignore preferred stocks out of fear or unfamiliarity, get in there. The rewards trounce the risks.

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Twenty-five bucks barely buys a beer and a burger at the best watering holes, but $25 is still a magic number in the investment markets. That's because $25 is the common par value for one share of preferred stock.

Preferreds are a terrific, if underappreciated, core high-income category. If you value portfolio income but ignore preferred shares or funds out of fear or unfamiliarity, get in there. The rewards trounce the risks.

Popular investment literature says little about preferred stocks except to note the small chance of skipped or suspended dividends. I see preferred shares as an alternate style of corporate bond, one with substantial and steady yield, excellent long-term returns – and an extra benefit from today's combination of massive demand and constricted supply. As with closed-end funds (CEFs), it is usually better to wait for shares to trade at a discount to par value than pay a premium.

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Go For Yield With Preferred Stocks

Elusive trading profits are not my priority. In this low-yield world, the lodestar for preferreds is a fixed or fixed-to-floating coupon of 5% or higher. The long-term average yield spread of the Standard & Poor's U.S. preferred index compared with the 30-year Treasury bond is 3.5 percentage points. Currently, the index yields 5.35%; the bond, 2.15%. Preferreds might look a bit pricey today, but not by enough to matter. (Yields and other data are as of Oct. 8.)

As for safety, bondholders get paid first, so S&P and Moody's sometimes rate preferred shares a notch or two below the same borrower's senior debt. This puzzles me, because to skip a preferred payment threatens the common stock, ends its regular dividend and savages the company's reputation.

"We think the ratings agencies over-penalize preferreds," says Jay Hatfield, whose company, InfraCap, manages the Virtus InfraCap US Preferred Stock ETF (PFFA (opens in new tab)), an actively managed preferred exchange-traded fund. So far in 2021, PFFA has a total return of 20.0% and covers its 7.7% distribution entirely from investment income. PFFA owns obligations of utilities, pipelines and real estate investment trusts (REITs). That 20% return is unsustainable. But since Virtus introduced the fund in May 2018, it has turned $10,000 into $13,455, for an annualized return of nearly 10%.

Another interesting opportunity: In June, Fidelity launched Fidelity Preferred Securities & Income ETF (FPFD (opens in new tab)), which is also actively managed. It started at $25 and is still at $25, so it is early to judge. But Fidelity unquestionably excels with its flagship junk-bond fund, Fidelity Capital & Income (FAGIX (opens in new tab)), and its bank-loan colossus, Fidelity Floating Rate High Income (FFRHX (opens in new tab)). I suggest you feed fresh cash equally among this Fidelity trio.

Another possibility is to invest via actively managed closed-end funds. A leading light among these is Flaherty & Crumrine, sponsor of several funds led by F&C Preferred Income (PFD (opens in new tab)). After soaring to a wild 30% above net asset value, the fund's premium is back to 6%, a rare buying opportunity. Because of volatile premium-discount swings, the fund is in the red so far in 2021, but its 10% annualized return over 10 years is superb. The current distribution of 6.4% is attractive and secure.

Jeffrey R. Kosnett
Senior Editor, Kiplinger's Personal Finance
Kosnett is the editor of Kiplinger's Investing for Income and writes the "Cash in Hand" column for Kiplinger's Personal Finance. He is an income-investing expert who covers bonds, real estate investment trusts, oil and gas income deals, dividend stocks and anything else that pays interest and dividends. He joined Kiplinger in 1981 after six years in newspapers, including the Baltimore Sun. He is a 1976 journalism graduate from the Medill School at Northwestern University and completed an executive program at the Carnegie-Mellon University business school in 1978.