Preferreds Continue in a Starring RoleAdvice to the Advisor
In the ever increasing search for income, preferred stocks continue to play an important role for companies and investors alike, with the Standard and Poor’s Preferred Index ETF (iShares: PFF) trading at an average share volume of 2.3 million/day as of May 23, 2017.
By way of quick review, preferreds are hybrid securities, blending traits of both stocks and bonds. Like common stock, preferreds represent ownership in a company, but without voting privileges; like bonds, preferreds are issued at a fixed par value and rated by independent credit rating agencies.
The fear on the part of many an investor these days is this: “If interest rates rise, won’t I lose a lot of money on my preferred holdings?”
Senior Portfolio Manager JR Humpreys, CFA, CAIA, “unpackages” the factors to consider.
Preferreds are concentrated in the financial sector. That means:
- Companies in this sector are so heavily regulated and scrutinized, their chances for an upgrade are greater than that of a downgrade.
- In a gradually increasing interest rate climate, insurance companies and banks would benefit (their “spread,” and therefore their profits, would likely increase).
- The U.S. has some of the highest interest rates in the world, and that has triggered a lot of foreign demand for our securities.
Humphreys reminds investors that “the Feds,” in making changes in interest rates, control only the short end of the yield curve; five-, ten-, twenty-, and thirty-year results are influenced by world economic growth and inflation expectations. “Rates can rise on the short end while on the longer end rates can drop, flattening the yield curve,” he explains. “With modest incremental rises in interest rates,” he says, “we think the curve may flatten even more.”
- When rates rise, banks might lend more money (the effect is capital flow in to the economy)
- When people are earning more on their investments, they can save less and spend more (again causing capital flow in to the economy)
One of the biggest risk areas in a preferred portfolio lies in the call feature, JR explains, offering the example of a preferred with a 6.58 coupon, a current yield of 6.27% callable in six months at 25. The yield sounds great in today’s low-rate climate. But if the security is trading at 26.51 and gets called at 25, the investor would lose money. Yield to call is more important than current yield, he cautions.
Sheaff Brock Preferred Income utilizes 20-25 preferred stock issue portfolios with three- to five-year call protection. Risk management is achieved through several tactics, including:
- Interest rate risk management—Fixed-to-float securities pay fixed dividends for five years from issue, then float with interest rates.
- Sell triggers—Humphreys sells when yield to call falls to an unattractive level.
“I’m an introverted geek, and I hate being average,” JR confided to the Sheaff Brock investment team. “I want the chance to win for Sheaff Brock’s clients.”