There’s a Method to Dealing with Preferreds

Advice to the Advisors

Sheaff Brock | Preferred Stock portfolio strategy | cat between dogs

There’s a Method to Dealing with Preferreds

Think of preferred stock as “middlers,” Sheaff Brock Senior Portfolio Manager JR Humphreys advises. Preferred stocks are income enhancers, yes, but they may have a higher return potential than bonds. At the same time, preferreds don’t act like other stocks, and, in fact, can carry less risk than their common cousins.

In speaking with our Institutional editor, Humphreys outlined the five basic considerations he uses in the selection process when building a preferred portfolio:

  1. Liquidity—Many preferred issues are small, making it difficult to “get in and get out of” advantageously, so Humphreys looks for issues of $10 million and above.
  2. Credit rating—Ratings, Humphreys explains, are particularly important, because preferred stockholders are “below” bondholders in the event of a default. At the same time, he notes, a BB rated security may offer a better chance of upward movement in price than one already rated Investment Grade.
  3. Yield measurements—Humphreys considers several factors:
    • actual coupon rate
    • current yield
    • yield to call
    • yield to worst (the lowest yield between yield to maturity and yield to call)
  4. Sell signals—In overlooking portfolio holdings of preferred securities, Humphreys explains, it’s important to ask these questions: How much are you being compensated for the risk that the company will call the security? Should you sell now and buy a security that goes further out?
  5. Issue-specific considerations—Just because a company can call its preferred stock doesn’t mean it’s in their best interest to do so, Humphreys notes. Preferreds tend to be concentrated in the financial area, and banks and other financial institutions must, by regulation, have equity on their books. As portfolio managers, we strive to regularly assess each issuer’s likelihood of retaining their preferred assets, he adds.Not all issues of preferred stock are in the financial sector, Humphreys pointed out. Utilities and growing companies in other sectors offer opportunities to diversify the portfolio of preferreds.

Asked about the “dangers” of holding preferred stock in a rising interest rate climate, Humphreys offered two reassurances:

  • Banks and insurance companies can actually benefit from gradually increasing rates (their “spread” and therefore their profits would likely increase).
  • “Fed” changes control only the short end of the yield curve. The five-, ten-, twenty-, and thirty-year results are influenced by world economic growth and inflation. “We think the yield curve may actually flatten with modest incremental interest rate rises,” he concludes.

An advantage of preferred stocks in a portfolio can be their lack of correlation, JR Humphreys reminds investors. “Preferreds simply don’t act exactly like either stocks OR bonds.”

 

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