Fear creates growth opportunities in preferred stocks

Seldom does an investment possess the combined virtues of manageable risk, rock-bottom prices and good prospects for growth, all with high dividend yields.

These are the current characteristics of preferred stocks, a kind of bond-stock hybrid investment that trades like stocks but pays interest like bonds — only much more of it. About two-thirds of preferred shares are issued by the banking sector, so most investments in preferred stock funds are in those in banks, primarily large ones.

Preferred stocks are a great source of portfolio income. Yet a current dip in prices presents significant potential for capital appreciation, as well.

Risk-reward characteristics for this small investment universe (totaling less than $1 trillion) have improved markedly since March, when fear stemming from the failure of two regional banks, Silicon Valley Bank and Signature Bank, pushed overall preferred prices down to rarely seen levels.

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What many investors feared would be a national banking crisis hasn’t materialized and probably won’t because regulators have intervened to restore stability in regional banks. And contrary to early fears, large banks haven’t materially been affected. Yet preferred prices generally remain depressed, creating opportunity for investors who don’t mind wading in when the water is still a bit muddy.

Peering into the swirl of market conditions, investors capable of seeing clear discounts instead of faux risk can position for potential growth while getting yields far superior to those of bonds — in many cases, 7% to 8% from preferred shares and 6% to 7% from funds. Dividends are fairly reliable because corporate boards are loathe to cut them, for fear of discouraging investment.

The recent dip in preferred share values can be seen in the price of iShares Preferred and Income Securities (PFF), a passively managed exchange traded fund yoked to the ICE Exchange-Listed Preferred & Hybrid Securities Index. Typically, this fund trades between about $40 a share and the mid-$30s. At the peak of the equity market in January 2022, it was trading at $39. In the ensuing weeks, as the Federal Reserve got into its rate hike cycle, PFF dipped to $34.

Then in March, headline-driven fears tamped this ETF down to about $30 a share for only the third time since banks started issuing preferred shares in the early 1980s. As of April 19, shares of PFF still hadn’t bobbed up much, hovering a bit over $31.

Prices are likely to rise as fears abate, and longer-term prospects are historically sanguine, given the likelihood of overall equity market growth by next year. Data from preferred-fund manager Cohen & Steers, shows that preferred stocks have risen an average of 29.7% over the six-month periods after market troughs since 2009.

But for now, preferred shares languish in doldrums sustained by lingering fear that resists countervailing information. The problems at the failed banks weren’t the result of any systemic risk present in the broader industry, but simply of poor financial management.

Moreover, the federal government isn’t likely to let banks fail, and least of all in the year before a presidential election year. In the case of the two regional banks, a strengthened federal safety net came into play, with broadened guarantees on deposits and a new Federal Reserve program that lets banks borrow against bond holdings at par.

The current pricing window not only increases prospects for capital gains as fears abate, but also reduces risk, sustaining dividends. Preferred shares are such a reliable source of yield that many institutional investors hold them perennially for income alone as a higher-yielding alternative to bonds. And dividends on many preferred issues are the tax-friendly qualified variety.

Though preferred shares have bond-like characteristics, they’re not a true form of corporate debt. Banks like to issue them because unlike bonds, they don’t count as debt toward required capital ratios. They don’t appreciate as much as common shares, and their owners rank behind bondholders (but ahead of common stockholders) for claims on assets if an issuer goes belly-up.

Here are some points for investors to keep in mind:

• Stick with funds when possible. Assessing duration risk, credit risk and the specific dynamics of preferred share issues can be quite complicated and often requires information largely inaccessible to most retail investors. So, most individuals are better off avoiding direct investment and sticking with funds.
• Those who do choose to invest directly should spend the time to learn about these investments and choose carefully. A common pitfall is to focus on yield alone and overlook duration risk — shares’ sensitivity to interest rates, which affects how long it takes investors to be reimbursed for their purchases. Duration is critical to real returns.
• Minimize the call risk common in passively managed funds. Actively managed funds are usually preferable, as managers can avoid or trade out of callable shares trading at a negative yield-to-call that populate indexes. Callable status contractually gives issuers the option to call or buy back shares for the original issue price (uniformly $25 for retail shares), regardless of whether current holders paid more on the open market. If these investors haven’t owned shares long enough to collect sufficient yield, a status known as negative yield to call, they could be in for a close haircut if shares are called. With passively managed funds — those that track indexes — investors can’t avoid exposure to callable shares trading at a negative yield-to-call, and this hamstrings fund performance. The higher fees of active management are less relevant because yields are after fees; some of these funds have dividend yields over 8%.
• Go pro. Investors can reduce risk by owning funds that hold less-volatile institutional preferred shares. Even some funds that are wholly institutional are accessible to individual investors. These are harder to find, but they’re around. ETF and mutual fund examples include Principal Spectrum Preferred Securities Active ETF (PREF), First Trust Preferred Securities and Income ETF (FPE), PIMCO Preferred and Capital Securities Fund Institutional Class (PFINX) and Cohen & Steers Preferred Securities and Income Fund, Inc. Class I (CPXIX).

Owning common stocks is about waiting for shares to rise, and buying bonds is a guarantee of low (and probably soon-declining) yield. By contrast, while the current pricing window remains open, investing in preferred stocks is about collecting substantial income while positioning for likely price appreciation in the coming months.

—   By Dave Sheaff Gilreath, chief investment officer and co-founder, and Edward “JR” Humphreys II, senior portfolio manager, Sheaff Brock Investment Advisors and its institutional arm, Innovative Portfolios