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Yield-Hungry Investors Should Consider Preferred Stocks

As yields in the US market continue to drop, income-oriented investors will need to be creative

As interest rates in the U.S. continue their downward march, approaching the negative interest rate environment in Europe, many investors are attracted to the relatively high yields offered by an instrument that offers the safety and security of a bond, while allowing for the potential to participate in the appreciation of the investment, much like the holders of an enterprises common stock.

Preferred stock can offer investors the best of both worlds: relative safety and high yields. These hybrid instruments typically offer more robust payouts than U.S. Treasury Securities and more safety than common stock, as preferred shareholders are priority creditors in the event of a liquidation.

The dual characteristics of preferred has made the $500 billion market a haven for those whose quest for better than paltry yields, as well as safety, has proven unattainable.

Companies usually issue preferred stock with a “par” or face value of $1,000 and a fixed dividend rate. The lower risk presented by preferred stock is that its dividends must be paid first, before a corporation’s common stock holders receive any distributions. The priority rights of preferred shareholders are spelled out in a covenant between them and the issuing corporation.

Indeed, the company is contractually obligated to give preferred shareholders priority in dividend distributions. For some preferred issues, the company must make up any fixed preferred dividends that are in arrears, in addition to the preferred shareholders fixed payout, before it can distribute any dividends to common holders. Some corporations issue convertible preferred stock that allows holders, under certain specified

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conditions, to convert the preferred into shares of common stock. The fixed interest rate on such instruments may be lower, however, due to the conversion privilege.

How much better are the yields on preferred stocks than other fixed-income investments?

Compare the dividend rate on JPMorgan Chase & Co.’s (NYSE:JPM) preferred issue that pays a dividend rate of 6% against the current rate on the 10-year Treasury note, which currently yields 1.749%, and the current dividend yield of the S&P 500, which is approximately 1.92%. However, the preferred stock’s much higher yield than Treasury bonds is lower than the 21% increase in JPMorgan’s common stock.

Depending on the issuer, preferred stock varies little from its par or stated price. The face amount or par value, similar to bonds, can increase or decrease depending on the interest rate environment and the financial status of the issuer.

The easiest way to enjoy the benefits of preferred stock is through the purchase of an exchange-traded fund. The Invesco Preferred ETF has risen 12% year to date. That increase is its largest one-year gain since the fund’s launch in 2008. Although this return is lower than the 19% gain in the S&P 500, it has far surpassed returns on investment-grade bonds. A good comparison measure is the iShares Core U.S. Aggregate Bond ETF, which has increased 6.3% in 2019.

It should be noted, however, that even though preferred shareholders enjoy priority over common stockholders, preferred issues are subordinate to a company’s bondholders, which could include various levels of bondholder priority status such as subordinated debentures, and other collateralized debt instruments. All of these obligations would need to be satisfied before preferred shareholders could participate in any liquidation proceeds.

However, a few caveats apply. The fact that preferred stock has priority over common in the event of a dissolution means precious little if there are insufficient assets to payout preferred over common shareholders in the hierarchy of priority creditors in liquidation.

Thus, even though preferred may be viewed by investors starved for yield as offering the safety of a bond, this priority payment guaranty means little if the company has high debt or dismal earnings. This principle of fixed-income risk is eloquently stated by Graham & Dodd in “Security Analysis,” when they warned:

“No special investment quality attaches to guaranteed issues as such. Inexperienced investors may imagine the word ‘guaranteed’ carries a positive assurance of safety; but, needless to say, the value of any guaranty depends strictly upon the financial condition of the guarantor. If the guarantor has nothing, the guaranty is worthless.”

An additional risk of owning a preferred ETF is that the preferred market is eclipsed by the broader stock market. Given the fact they are thinly traded, preferred ETFs can be susceptible to volatility, regardless of the stability of its constituent holdings.

During the later months of 2018, fears of an economic downturn, increased trade tensions with China and the prospect of higher interest rates jolted markets. The Invesco Preferred ETF was among those affected, dropping 5.9% — its biggest quarterly decline in two years.

There has been no indication from the Federal Reserve that interest rates will be increased anytime soon. Given this reality, those seeking the highest return commensurate with relative safety would do well to explore the benefits of preferred stock.

This article originally appeared on gurufocus, the value investing site

About the author:

John Kinsellagh is a freelance writer, former financial adviser and attorney specializing in civil litigation and securities law. He completed the Boston Security Analysts Society course on investment analysis and portfolio management.

He has served as an arbitrator for FINRA for over 25 years resolving disputes within the financial services industry. He writes primarily on financial markets, legal and regulatory issues that impact the investment community, and personal finance.

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