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A Preferred Source of Yield

By Bryan Perry

One of the hottest themes for big-cap money managers coming out of the Great Recession was taking a stake in high-yielding preferred stocks of companies backed by the Troubled Asset Relief Program (TARP) funds. It seemed the government‚??s promise to ‚??do whatever it takes‚?Ě to breathe life back into the banking system had attracted fresh interest in the otherwise blown-out financial sector. And looking back, it was a very profitable trade that paid off hugely.

During the past five years, following three rounds of quantitative easing (QE), there has been vast improvement in the corporate debt markets as balance sheets have strengthened with the economic recovery. However, if the Fed elects to wait on raising interest rates at this week‚??s Federal Open Market Committee (FOMC) meeting, investing in preferred stock, a junior security to that of a company‚??s bonds but senior to common stock holders when it comes to priority in paying out dividends, might well be a green-light opportunity to capture yield.

Preferred stocks got smoked with the credit markets in the latter part of 2008, to a point where the definition of ‚??capitulation‚?Ě was re-written for all time. You think corporate bonds got sold down in a big way? It was nothing compared to what holders of Preferred Stocks went through.

But now, with the TARP funds fully repaid, three rounds of QE priced into the market and signs of a global slowdown emerging from China, fund managers who believe the Fed will stand pat have been legging into high-quality preferred shares backed by the nation‚??s largest companies in what has been a minor correction for corporate debt markets.

Here are the key components to owning Preferred Stocks in a portfolio:

  • It is stock whose holders are guaranteed priority in the payment of dividends but whose holders have no voting rights;
  • A stock that has prior claim on dividends (and/or assets in the cases of corporate dissolution) up to a certain amount before the common stockholders are entitled to anything;
  • Stock that is entitled to a stipulated dividend before any dividend can be declared on the ordinary or common stock;
  • A separate and/or secondary class of stock issued by some corporations. Preferred stock typically has limited or no voting rights, but its holders are paid dividends or receive repayment priority in the event the corporation is liquidated.

Simply speaking, from a priority standpoint of who gets paid first when earnings come out, owners of preferred stocks are below the corporate bondholders but above the common stockholders — but usually without a vote, because preferred stocks, by definition, are debt and not equity.

Enter preferred stock exchange-traded funds (ETFs) like the iShares U.S. Preferred Stock Index Fund (PFF), which could signal a new uptrend in the face of any data that suggests that domestic economic growth is hitting a plateau. And this particular basket security would be a very good fit for income investors seeking a monthly payout with an investment-grade yield of 5.35%.

pff_0911

As a professional money manager and market trader, I‚??m always looking for a safe place to consider parking capital if the bond market gets a firm bid. The three-year chart above of PFF shows a nice pullback in the shares as nervous holders of long-term debt instruments fear the Fed will hike rates this month and begin a new tightening cycle.

This ETF is now sitting on its long-term 200-week moving average right around $38.80 and needs to hold this level — or it will surely trade lower, probably as a result of the Fed in fact hiking its Fed Funds Rate by a quarter point.

YIELD POWER

Relative to the 10-year, 20-year and 30-year Treasuries, the preferred stocks that make up the holdings of this ETF are throwing off some serious yields, with 96% of the companies held being in the financial sector. The fund owns 292 separate holdings with net assets sitting at $13.3 billion, making it one of the largest ETFs. Below is a table of the fund‚??s top holdings:

Top 10 Holdings (16.47% of Total Assets)  
Company Symbol % Assets
Allergan Plc Preferred Stock 5.5 AGN 3.01
Hsbc Holdings Plc Preferred Stock 8.0 HSBC 2.28
Barclays Bank Plc Preferred Stock 8.125 BACR 1.62
Gmac Capital Trust Preferred Stock 8.125 ALLY 1.60
Wells Fargo & Company Preferred Stock 8.0 WFC 1.43
iShares Short Treasury Bond SHV 1.41
Hsbc Holdings Plc Preferred Stock 8.125 HSBC 1.37
Citigroup Capital XIII C 1.37
Deutsche Bank Contingent Capital Trust DB 1.27
Frontier Communications Corp. Preferred Stock FTR 1.11

Bear in mind that preferred stocks are typically issued with 25-year maturities and trade like long-term corporate bonds where if rates rise, they will get hit — and hit hard. So it‚??s best to wait to see how the Fed is positioning its fiscal policy for the year-end and then decide if adding shares of PFF to one‚??s portfolio is prudent.

The bottom line with this strategy is that if interest rates are down for the count, as some bond bulls firmly believe, then snapping up a 5.35% yield on PFF shares versus 2.92% for a 30-year Treasury is a very attractive alternative for investors seeking investment-grade debt instruments.

SECTOR STRENGTH

There are many types of preferred shares, including cumulative, callable and convertible. The prices of preferred shares typically have had more volatility than bonds but jump around less than common stock. Another reason investors are drawn to preferred shares is that the dividends, which are fixed, can be taxed at a lower rate than the income thrown off by bonds. In the case of PFF shares, 64.27% of the income received in 2014 was in dividends that were taxed as ‚??qualified dividend income,‚?Ě or QDI, the max rate being 20% to shareholders. Keep an eye on the Fed and PFF this week. If the Fed doesn‚??t move, shares of PFF will, and that move will be higher.

In case you missed it, I encourage you to read my e-letter column from last week about a British banking group. I also invite you to comment in the space provided below my Eagle Daily Investor commentary.

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