Low interest rates mean that investors can no longer generate the income they need (and were used to). This dilemma has triggered a search for higher-yielding alternative forms of fixed income investing. Those investors who choose preferred stocks must understand the hidden and obvious risks.
With nearly $18 billion in assets, the iShares U.S. Preferred Stock Fund (PFF) is by far the leading ETF with exposure to preferred stocks. Its current 12-month yield is 5.62%, which explains investor interest in the fund. The question I will examine is the following: What role, if any, should preferred stocks play in your portfolio? I begin with a brief description.
Important details about preferred stocks
Preferred stocks are technically equity investments, meaning investors who own these securities rank behind debt-holders in the lineup of credit priority. While preferred shareholders receive preference over common equity holders in the case of a bankruptcy, all the debt-holders would have to be paid off before any payment would be made to the preferred shareholders. And, unlike equity shareholders who benefit from any growth in the value of a company, the return on preferred stocks is primarily a function of the dividend yield, which can be either fixed or floating.
Preferred stocks are either perpetual (they have no maturity) or long term (with a maturity typically between 30 and 50 years). Preferred stock issues with a stated maturity of 50 years may include an issuer option to extend it for an additional 19 years. Investors who are considering the purchase of a long-term preferred stock should ask themselves: I purchase a bond from the same firm paying the same interest rate with a 69-year maturity?
The answer should be, “No!”
Why? Because the maturity is too distant, well beyond the investment horizon of most people. The very long-term maturity of preferred stocks also creates a problem. Among fixed income investments, the longer maturities have the poorest risk/reward characteristics (the lowest return for a given level of risk). The long maturity typical of preferred stocks is not the only problem with these securities. They typically also carry a call provision.
Asymmetric risk
A call provision gives the issuer the right, but not obligation, to prepay the debt. U.S. government debt (as well as all non-callable debt instruments) has no call provision, so it has what is called symmetric price risk. A 1% rise or fall in interest rates will result in roughly the same change in the price of the bond (but in the opposite direction) for each unit of duration. This is not the case with callable preferred stocks. The reason is that if rates rise, the price of the preferred stock will fall; if rates fall, and if the issuer is entitled to do so, the preferred stock will be called in and likely replaced by a new preferred-stock issue at a lower rate, conventional (and cheaper) debt or perhaps even equity. Thus, you have asymmetric risk – you get the risk of a long-duration product when rates rise, but the call feature puts a lid on returns if rates fall.
Another risk associated with buying callable preferred stocks is that the call feature isn’t related only to interest-rate risk, but also to the risk of changes in the company’s credit rating. A company that has low-rated credit and a high-yielding preferred stock issue likely will call in the preferred stock if its credit status improves. It would then replace the preferred stock with a then higher-rated conventional corporate bond (and take advantage of the tax deductibility of coupon payments). Of course, if the company’s credit deteriorates, it will not call in the preferred stock (but the price of the preferred stock will fall due to the deteriorated credit). Again, this results in asymmetric risk for the investor.
There is yet another critical point to cover. Longer-term maturities with fixed yields do provide a hedge against deflationary environments. However, the problem with longer-maturity preferred stocks is that the call feature negates the benefits of the longer maturity in a falling rate environment. Thus, the holder fails to benefit from the rise in price that would occur with a non-callable, fixed-rate security in a falling rate setting. If the issuer isn’t able to call in its preferred stock, it is likely because of a deteriorating credit rating, putting the investor’s principal at risk. Given that preferred issues are often from companies with weaker credit ratings, and those distressed companies are the very ones most likely to default in deflationary environments, the benefit of the high-yielding longer maturity is unlikely to be realized by investors holding these callable instruments.
The result of all the asymmetric risks is that preferred stocks rarely trade much above their issue price.
Most callable preferred stocks are callable at par. Thus, there is extremely limited upside potential (virtually none if the call date is near) if the security is purchased at par. Having call protection is important to income-oriented investors for another reason: callable instruments present reinvestment risk (the risk of having to reinvest the proceeds of a called investment at lower rates). Through calls investors lose access to relatively higher income streams. Thus, part of the incremental yield of preferred stocks relative to a non-callable debt issuance from the same company is compensation for the giving the issuer the right to call in the debt should the rate environment prove favorable. Let’s look at the other source of the higher-stated yield, the credit risk.
Credit risk
While not all preferred stocks are in the junk bond category, they seldom are highly rated credits (although there are some exceptions). Consider the iShares U.S. Preferred Stock ETF (PFF) as of June 30, 2016. Only about 1% of the fund’s holdings were AAA-rated, less than 2% were AA-rated and less than 11% were A-rated. Thus, a total of only about 14% of the fund’s holdings were A-rated or higher. On the other hand, 56% of its holdings were BBB-rated, the lowest investment-grade rating. A further 20% were BB-rated. About 4% were B-rated, and about 7% weren’t even rated at all.
Preferred stock dividends are paid at the discretion of the company. Thus, in times of financial distress, dividends on preferred stocks could be deferred. Just when you need those dividends the most (during times of economic hardship) the risks show up. Bond interest payments, however, represent a contractual obligation and failure to pay triggers a reorganization.
Concentration risk
For the regulatory reasons mentioned previously, the issuers of preferred stock tend to be heavily concentrated in the financial sector. This creates additional risk of limited diversification. For example, as of March 2016, 60% of PFF’s holdings were in the financial sector: 42% were issued by banks, and 18% were issued by diversified financial companies. Further, 14% were issued by real estate companies, and 9% were issued by insurers.
Why do companies issue preferred stocks?
Given the lower cost of tax-deductible conventional debt (equity preferred stock dividends are not deductible), one has to ask why companies issue preferred stock, especially when traditional preferred shares are rated two notches below the issuer’s rating on unsecured debt (lower credit rating increases the cost of capital). The answer is not reassuring. They may issue preferred stocks because they have already loaded their balance sheet with a large amount of debt and risk a downgrade if they piled on even more. Some companies issue preferred stock for regulatory reasons. For example, regulators might limit the amount of debt a company is allowed to have outstanding.
Another regulatory reason comes into play. In 1996, the Federal Reserve allowed U.S. bank holding companies to treat certain types of preferred stocks (what are called hybrid preferred stocks) as Tier 1 capital for capital adequacy purposes. An additional reason for issuing preferred stock is that it can be structured to appear like debt from a tax perspective and equity from a balance sheet perspective. Instruments structured in this manner are called trust preferred stocks.
Investors benefit from thinking of the situation from the issuing company’s perspective. Most companies with a solid credit rating do not issue preferred stocks (except for regulatory reasons) because the dividend payments are not tax deductible. Thus, preferred stocks are generally too expensive a form of capital for strong credits. Before buying a preferred stock, an investor might ask why a company would issue preferred stocks paying a generous dividend in the first place when the company could presumably issue debt securities with more favorable tax consequences. Investors seeking safe returns are generally not going to like the answer.
Which brings us to another question: Are there any good reasons to buy a preferred stock?
Preferential tax treatment
Corporations receive favorable tax treatment on the dividends from preferred stock, with the vast majority of the dividend income not subject to taxes. U.S. corporate holders can exclude up to 70% of the dividend from their taxable income provided they hold the shares for at least 45 days. This favorable tax treatment creates demand for the product from investors who receive this benefit, driving the price higher than it would be without the preferential treatment (and lowering the yield). Individuals get no such favorable tax treatment.
Summarizing what we have discussed so far, investors who buy preferred stocks because of their higher yield and, possibly, their fear regarding equity investing are taking on other risks. Because the markets are relatively efficient at pricing risk, higher yields must entail greater risk (something that investors were likely seeking to avoid in the first place). These risks include perpetual life (or a very long maturity), a call feature, low credit standing, deferrable dividends and, for traditional preferred stocks, a depressed yield because of the demand from corporations that receive favorable tax treatment.
Other negative features
There are some additional reasons to consider avoiding preferred stocks. Because of the need to diversify risks, one should not buy preferred stocks individually. That means you need to buy a fund, such as the aforementioned ETF, PFF, and incur expenses of 0.47%. Because investors in U.S. Treasuries, government agencies or FDIC-insured CDs don’t need to diversify their credit-exposure risk, they can eliminate the expense of a fund altogether. Or, for convenience, they can use funds with much lower expense ratios (such as those offered by Vanguard). Some of the higher yield that the market requires for preferred stocks will be spent on implementing the strategy. The result is that investors don’t earn the full risk premium the market requires.
If you buy individual preferred stocks issues, you have to consider the trading costs involved, the lack of diversification and the need to constantly monitor credit ratings.
Lastly, the typically long maturity of preferred stocks issues increases credit risk. Many companies might present modest credit risk in the near term, but their credit risk increases over time and tends to show up at the wrong moment.
Equity-like risk
A study by James Davis of Dimensional Fund Advisors found that for the period from October 2003 (the inception date of the preferred stock index) through February 2011, the monthly return correlation between preferred stocks and common stocks was 0.57, demonstrating that preferred stocks have a not insignificant exposure to equity risks.
You can observe evidence of this in the following data: The changes in NAV for PFF for the five quarters beginning in July 2007 (when the financial crisis began) were -3.8%, -9.2%, 3.3%, -4.1% and -28.0%. And in calendar 2008, PFF lost 23.9%. On the other hand, the SPDR Barclays Long Term Treasury ETF (TLO) gained 23.9%, an underperformance by PFF of almost 48%. Just when you needed your fixed income assets to provide shelter from the equity storm, preferred stocks suffered large losses similar to those experienced by junk bonds.
While data was only available for a short period, consider the following evidence. Davis found the annualized return for preferred stocks was 4.7%, just slightly higher than the 4.1% return on AAA-rated bonds and below the 6.1% return on stocks. Because the monthly standard deviation of preferred stocks (6.4) was higher than for either AAA-rated bonds (1.1) or stocks (4.4), preferred stocks produced the lowest monthly Sharpe ratio, 0.07, versus 0.09 for stocks and 0.15 for AAA-rated bonds.
Updating the data, we find similar results. From April 2007 (inception of PFF was March 26, 2007) through May 2016, the ETF returned 4.4% per annum and its standard deviation was 19.7%. The S&P 500 Index not only provided a higher return of 6.0%, but it did so with a considerably lower level of volatility. Its standard deviation was 15.9%. Despite its dramatically higher level of risk, PFF barely managed to outperform the 4.3% return of the Barclays U.S. Government Bond Index (1-30 Years), which it achieved with a standard deviation of just 4.3%.
Note also that the five-year U.S. Treasury note returned 4.1% over the same period, and did so with a standard deviation of just 3.9%. And while PFF lost nearly 24% in 2008, the five-year Treasury note gained more than 13%. This demonstrates how much more effective high-quality fixed income investments are as a diversifier of risk.
Further concerns become apparent in the results of a five-factor (beta, size, value, credit and term) analysis using the tool provided by Portfolio Visualizer. For the period from December 2009 through April 2016, the regression results show that PFF had a beta loading of 0.2 (t-stat of 2.9) and a loading on the credit factor of 0.51 (t-stat of 4.1). As with the analysis done by James Davis of DFA, this shows that the fund has a significant equity exposure (without the upside potential of equities) while also taking significant credit risk.
Finally, while fixed-rate, non-callable Treasury debt makes an excellent diversifier for stock portfolios – because a weak economy, which can harm stock prices, generally leads to falling interest rates and rising bond prices – preferred stocks, due to their call feature, won’t benefit as much, or even at all.
Conclusion
High yield is not a sufficient justification for investing in preferred stocks. If you want or need more risk than safe fixed income investments offer, own equities, where you can control risks more effectively, diversify more effectively and earn the risk premium in a more tax-efficient manner. Furthermore, the expenses for fixed-income assets will be lower. For example, buying FDIC-insured CDs allows you to completely avoid the expenses of a mutual fund.
Larry Swedroe is director of research for The BAM ALLIANCE, a community of more than 150 independent registered investment advisors throughout the country.
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