Preferred stocks: Have your cake and eat it too

Amid all the hair pulling over the economy and stock market these days, events have driven down prices of a relatively obscure investment, creating opportunity. That investment, unknown to many individual investors, is preferred stocks, a small corner of exchange-traded products totaling about $1 trillion.

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Preferred stocks pose an opportunity for investors to have their cake and eat it too. That cake is the high-dividend yields that preferred stocks are paying. But investors can eat their cake by taking likely gains in the coming months, with prices currently at historically low levels.

Preferred stocks are something of a bond-stock hybrid. They don’t rise as much as common stocks (what we normally just call stocks), but they also don’t fall as much. Many preferred share issues have current dividend yields of 7% to 8% — about twice that of long-term Treasurys — and many preferred funds, approximately 6% to 7%.

Of course, preferred stocks carry more risk than Treasurys, but these risks are highly manageable, especially now that a pricing dislocation has improved their risk-reward characteristics. The resulting window comes from fears about the overall banking industry triggered by the failure of a few regional banks, most notably Silicon Valley Bank (SVB), a cash repository for technology moguls and venture capitalists.

As things are turning out, these failures aren’t having much impact on the larger banking industry beyond spawning groundless fear and doubt. News coverage has driven down preferred stock prices because most preferred shares are issued by banks, notably large banks, which have gone largely unscathed by the regional banking crisis.

When you buy individual preferred shares, investing in banks is a matter of choice. This is not usually the case with preferred funds, where most holdings are bank-preferred shares. Preferred stocks are a great way to invest in banks, either directly or through funds. Annual dividends from bank common shares are paltry in comparison, often below the 3% to 4% range.

Preferred shares are structured differently to meet specific financial goals for companies that issue them. Their history goes back to the railroad boom in the 19th century. Banks started issuing them apace in the 1980s because they found them useful for raising money without manifestly parting with too many of their companies. This is because preferred stocks don’t rise as much as common shares. And unlike bonds, they don’t give holders a primary claim on assets if a company fails.

Like common stocks, preferred stocks represent pieces of companies and are traded on exchanges. Like bonds, however, the main reason many people own them is the income or yield that they pay. Although many investors (including ourselves) find these yields exciting — and so should private practice physicians lacking 401(k) plans and seeking income in retirement — preferred stocks have a reputation for being a bit boring. This is curious, considering that preferred dividends are of the tax-friendly, qualified variety.

More investors should find preferred stocks interesting since fear-driven price suppression has created greater potential.

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 (ETF) yoked to the Intercontinental Exchange Exchange-Listed Preferred & Hybrid Securities Index. Typically, this fund trades between approximately $35 and $40 a share.Previously, PFF has traded below $30 in only two periods, 2008-2009 and 2020 — times of economic crisis. In early May, PFF again dipped below $30.

This price remains low, but risks to banks could be greatly overblown. After all, federal regulators promptly stepped in to guarantee all deposits and quickly introduced a new, supportive guarantee program. Although the failure of another regional bank in late April, First Republic, prompted a media feeding frenzy, this too was much ado about a little because regulators again stepped in to secure deposits, this time in partnership with JPMorgan Chase & Co. Unlike the banking sector’s problems related to the financial crisis in 2008, these failures involved no systemic risk to the banking system. Instead, the common thread was financial mismanagement: overexposure to long bonds amid rising interest rates. So risk levels of preferred stocks in general haven’t changed, nor has their history of high dividends.

This income is perennially stable for the following reasons:

Dividends are generally reliable. As with common stocks, corporate boards are extremely reluctant to cut them because this discourages investment. Cuts tend to occur only after prolonged declines in value, so investors can see them coming. Also, cuts are usually restored when tough times pass.

Boards can’t cut dividends until they first cut them on common stocks. That’s because of preferred shares’ superior position in the hierarchy of shareholders and creditors known as the capital stack, hence why they are preferred. The capital stack ranks investors in the order in which they would be paid off if a company goes belly-up. Loans, senior debt and bonds come first. Preferred shares come next, and common shares come last. Unlike common shares, preferred shares usually don’t have voting rights, but few minor shareholders vote their common shares.

If history is any guide, even before fear tamped down prices, preferred stocks were already likely to rise in the coming months. Data from preferred fund manager Cohen & Steers show that preferred stocks have risen an average of 29.7% in the six-month periods after market troughs since 2009.

The banking system was already well fortified against disaster, although you wouldn’t know it from all the hysteria. Long-standing protections were shored up substantially after the financial crisis of 2008, prompting regulators to require increased capital reserves from banks, making them safer than they’d been for decades.

Consistent with this federal policy, after a bank run on SVB forced it to close, President Joe Biden took the unusual step of appearing on live television at 9 a.m. to discourage withdrawals by assuring the public that banks were safe. Yes, there are risks, but investors can manage them. Some tips:

Investing directly in preferred stocks can be tricky for individual investors — involving the assessment of duration risk, credit risk and the specific dynamics of preferred share issues — so this is best undertaken with help from an adviser with access to information inaccessible to most individual investors.

Stick with funds that are actively managed, because managers can minimize risk by avoiding shares with an onus known as negative yield to call. These shares tend to populate indexes tracked by passive funds. 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, they are negative yield to call; holders would be in for a loss if these shares are called. Passively managed funds have exposure to these shares. Actively managed funds have higher fees, but these yields are after fees, and some of these funds have dividend yields over 8%.

Follow the professionals. Investors can reduce risk by owning funds that hold fewer 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. ETFs and mutual fund examples include Principal Spectrum Preferred Securities Active ETF, First Trust Preferred Securities and Income ETF, Pacific Investment Management Company Preferred and others.

By adding a reasonable portion of preferred stocks to their portfolios before the current pricing window closes, investors can have some tasty dividends immediately and eat the cake of capital appreciation down the road.

Dave S. Gilreath, CFP, is a partner and chief investment officer of Sheaff Brock Investment Advisors LLC, a portfolio management firm for individual investors, and Innovative Portfolios LLC, an institutional money management firm.

Edward “JR” Humphreys II, CFA, CAIA, is a senior portfolio manager with both firms, specializing in fixed-income and alternative investments. Based in Indianapolis, Indiana, the firms manage approximately $1.4 billion in assets.