I grew up in and still live in the South. During the dog days of summer in July and August, when folks say, “It’s not the heat, it’s the humidity,” believe me, it’s the heat AND the humidity.
Everything wilts. People move more slowly. Business slows down a little, too. There’s a real and noticeable effect.
The fixed-income markets — represented by Treasurys, corporate and municipal bonds, and other income-oriented investments — experienced the dog days firsthand this summer as investors fretted over the prospect of the Federal Reserve scaling back its bond purchases, also known as tapering. Look what happened to the 10-year Treasury:
Over the summer, yields nearly doubled, shooting from 1.6% to almost 3%. Naturally, this caused plenty of chaos in the bond market. However, chaos always brings opportunity.
When it comes to adding a fixed-income component to an investor’s asset allocation and providing an above-average income stream, preferred stocks are one of the most useful tools available.
Preferred stocks are typically classified as part of the issuing company’s debt structure. However, unlike bonds, preferreds are issued in face values smaller than $1,000 and are junior to bank loans and bonds. Preferreds are, however, senior to a company’s common stock within its capital structure.
Also, dividends on preferred stocks can be higher than that of the common stock. For example, Bank of America’s (NYSE: BAC) common stock currently pays an annual dividend of $0.04 a share for a measly yield of 0.27%. In contrast, Bank of America Preferred Series E (NYSE: BAC-PE) pays an annual dividend of $1 a share — a yield of about 5% based on a share price near $20. What’s more, the preferred stock trades at a 25% discount to its $25 face value.
Not only does the holder receive an attractive yield, there’s also upside. The recent interest rate turmoil has created what I see as obvious inefficiencies in the prices of many preferred stocks. For investors, this is a great opportunity to pick up growth and attractive income in a traditionally conservative investment sector.
While there are many opportunities in individual names, the most logical approach would be to select a basket of well-known preferred stocks. Two widely held exchange-traded funds help accomplish this: the iShares U.S. Preferred Stock ETF (NYSE: PFF) and the PowerShares Preferred Portfolio (NYSE: PGX).
While both funds share similar traits, there are some interesting differences.
The PFF price chart is almost the exact inverse of the chart for the 10-year Treasury yield. Tapering anxiety brought shares of PFF down almost 10% off its recent highs. In turn, the discount pushed the dividend yield up past 5.3% — not bad considering how the yield on the 10-year Treasury has “rocketed” all the way to 2.7%.
However, the turnoff is that PFF’s top 10 holdings include the world’s largest banks, many of which teetered on the brink of disaster during the 2008 financial crisis and the 2011 European sovereign debt crisis. But financial company preferreds aren’t all bad.
In fact, thanks to recent reform laws, there’s actually an implied support for the prices of financial services company preferred stocks. The Basel accords that govern international banking laws and the much-maligned Dodd-Frank Wall Street Reform and Consumer Protection Act, which seeks tighter regulations on domestic banking, both dictate that financial institutions no longer include some preferred stocks in their Tier 1 capital ratio, which is the most important measure of a bank’s liquidity.
As a result, many of the larger institutions are retiring their preferreds with longer-term subordinated debt. This activity is shrinking the supply of preferred issues, which serves to prop up share prices.
The PowerShares Preferred Portfolio is another good option for investors looking for value and preferred stock exposure.
Like PFF, PGX shares are off nearly 10% since its 52-week high above $15. The dividend yield now stands at 6.7%.
While PGX is similar to PFF in that the lion’s share of its preferred stock holdings are from the financial services sector, (at 88% and 71% respectively), PGX’s credit quality is noticeably stronger. Nearly 66% of PGX’s names are rated investment grade (BBB/Baa or better). PFF, on the other hand, has only 15% of its basket in the investment-grade space.
Risks to Consider: In addition to concerns over the credit quality of each ETF’s portfolio, the biggest risk to PFF and PGX is further price erosion due to interest rate volatility brought on by tapering concerns. The trade-off, of course, is the generous dividend yield.
Action to Take –> Thanks to fear, the opportunity has been presented to investors looking to pick up high-quality, above-average income at an attractive discount. PGX and PFF offer a blended yield of better than 6%. Based on interest rates stabilizing and the supply of preferred stock continuing to contract, investors could receive total returns of 16% to 20% along with a steady income stream in a liquid vehicle. Not bad for a conservative investment choice.