Harnessing Twin Risks can Turn Preferreds into Portfolio WorkhorsesAdvice to the Advisor
In any income portfolio, two “bug-a-boos” are credit risk and call risk. When it comes to preferred stocks, interest-yield-hungry investors tend to over-emphasize the former, even as they devote less than due attention to the latter, observes Sheaff Brock Senior Portfolio Manager JR Humphreys.
“Investors in search of solid income from their portfolios often select preferred stocks rather than Treasury securities or ETFs based on Treasury bonds. One reason behind this decision is that preferred stocks generally pay dividends of approximately 6% per year,” explains Investopedia.com. (A secondary advantage is that preferred shares’ dividends may be taxed as long-term capital gains, Investopedia adds.)
The iShares US Preferred Stock exchange-traded fund (ticker: PFF) tracks an industry benchmark, the Standard & Poor’s U.S. Preferred Stock index, showing that preferreds often offer higher yields than either stocks or bonds, many “upwards of 5, 6, or even 7 percent,” Jeff Brown writes in U.S. News. This extra yield is hardly free of risk, as you, the advisor, are no doubt careful to remind equity investors. Preferred stocks present credit risks and industry sector risks, meaning that, should the general economy “tank,” or should there be an industry upheaval, there is always a risk of corporate bankruptcy.
The “elephant in the living room,” a factor less frequently understood—and perhaps less frequently discussed by advisors with their clients—is call risk. Quotations pages typically display current yields, ignoring yield-to-call. The reality is that many of those listed preferred stocks trade at negative yield-to-call. For income-dependent investors anticipating a 6 to 7% dividend, calls can result in a loss of high-coupon payments with a possible “loss of principal for any security purchased above par,” according to Cara Esser, fund strategist at Morningstar.
In managing the Sheaff Brock Preferred Income Portfolio, Humphreys firmly states, a wide variety of preferred types must be combed to uncover stocks that have the potential to deliver steady and consistent income while at the same time preserving capital. That means giving “weight” to both types of risk. An initial list of 300 stocks, researched and ranked by not only call date and credit rating, but yield-to-call, is narrowed to 20–25 choices. If yield metrics later fall below an acceptable level, the issue will be replaced.
In the interest of diversifying risk, the Preferred Income Portfolio consists of different types of preferreds, including:
Harnessing the twin risks—credit risk and call risk—the veteran portfolio manager concludes, can help turn preferred stocks into portfolio workhorses!