How Preferred is Preferred?

What are preferred stocks?

“Preferred Stock Cologne” by Coty. Source: 99perfume

Preferred stocks are hybrid securities that fit between equity and bonds in a firm’s capital structure. Most of the time, if a company goes through bankruptcy, the preferred shares get wiped out. During the financial crisis, the owners of the preferred shares of Fannie Mae and Washington Mutual got nothing for their shares, while the bondholders received 100 cents on the dollar.

So in what sense are they preferred? They are preferred as to their dividend. Preferred dividends are fixed, and usually pretty high. If a company gets into financial trouble and wants to suspend its preferred dividend, it has to cancel the common dividend first. And many preferred dividends are cumulative: before a company can resume dividend payments to its common shareholders, the accumulated unpaid dividends on preferred shares have to be paid.

For years, preferred stocks lagged the financial markets. They didn’t provide the growth of common shares, since they weren’t the final residual in the capital structure. But they weren’t as stable as bonds, either. When things go wrong, preferred shareholders are often lumped together with common shareholders. They’re really super-subordinated long-term bonds. The only companies that have issued them to any great extent have been banks, where they help with certain regulatory ratios.

Until recently.

Our current yield-starved environment has touched off a feeding frenzy in preferred shares. The broad equity indices pay less than 2%; 30-year US government bonds pay less than 2.5%. Even emerging market and junk bonds don’t yield very much. So investors have been giving preferred shares another look. And so far, they like what they see. Over the past year, the S&P Preferred Stock index is up over 8.5%. And it still yields more than 5%.

This is striking, when you look at what’s in the index. Over 80% of its constituents are banks, insurance companies, and other financial firms. Essentially preferred stocks are subordinated bonds in a subordinated portion of the economy. And we know what happened to that sector during the last economic downturn. In the aftermath of the financial crisis, preferred stocks fell over 60%, and have yet to return to their pre-crisis levels.

S&P Preferred Stock Index. Source: Bloomberg

For now, though, investors can’t get enough of the high-paying shares. The assets in the popular iShares Preferred Stock fund (PFF) have grown from $14.3 to $17.5 billion so far this year – in a market with only $190 billion in market capitalization. That’s less than Pfizer’s market cap – the 25th largest US company. When one fund owns 10% of the market, the market owns that fund – not the other way around.

This is a prime example of “reaching for yield”: moving down in credit quality and out in maturity to capture more income. And it does not usually end well for the “reachers.”

Douglas R. Tengdin, CFA

Chief Investment Officer

By | 2017-07-17T12:21:51+00:00 August 15th, 2016|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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