A while back, I posted something on the possible advantages of buying preferred stock ETFs versus individual preferred stock securities. The tradeoff of receiving a slightly lesser yield in return for some personal time savings seemed worthwhile to me when interest rates were low and stable. As we seem to have now entered a period when interest rates appear to be moving upward, I wanted to revisit my approach to preferred stocks to see if there might in fact be opportunities that may be better options than just holding ETFs.
Preferred stocks are fixed income vehicles that trade essentially like bonds. There are different varieties of preferred stock, but in general they are similar to bonds in that they pay dividends at a fixed coupon rate. Like bonds, the price movements of preferred stock are heavily correlated to changes in interest rates (not to the price of the common shares of an issuer). Unlike a bond, a traditional preferred stock does not have a maturity date and is considered a perpetual security. Preferred stock is also callable by the issuer after a certain date. When preferred shares are called, the issuer buys back your shares at the par value of the security. Some preferred stocks are “non-cumulative” in nature, meaning that if an issuer skips a dividend payment, there is no requirement to make up that payment later. As you can see, there is significantly more risk with investing in preferred stocks than with bond investing, but the tradeoff is that the yields you get with preferred stocks are higher than what you can get with bonds. On the risk/reward scale, preferred stock would rank higher up than bonds, but lower than dividend-paying common stocks, REITs, or MLPs.
Doing good research is especially important for investing in preferred stock. If you intend to hold the stock for a long time, then you need to make sure the issuing company has a sustainable business and is in solid enough financial condition to continue paying dividends for that duration. On the other hand, some investors just use preferred stocks as an alternative to bank CDs to park their cash in for a few years. If you intend to eventually sell your preferred shares, then you also need to make sure that you purchase shares at a price where your expected returns are worth the risk and that a liquid market for the shares exists when it is time for you to sell.
In an environment in which interest rates are expected to rise, what is a good strategy for picking preferred stocks? My first screen is always to look for preferred stocks that meet some basic criteria:
- Must be cumulative
- Must not be callable for at least 3 years
- Must offer relatively high yield
- Issuer must be in a strong financial condition with a good credit rating
To select individual securities that might outperform an index of preferreds, I then consider the current economic forecasts and how they would affect the securities that meet the above four criteria. In general, when interest rates rise, they:
- Discourage companies from calling their preferred shares (so, I can probably consider securities with a shorter period before the call date than I otherwise would)
- Benefit bank and insurance businesses (strengthening their ability to sustain dividend payments)
- Favor real estate trusts that hold shorter-term leases (also making it more likely they will be able to sustain dividends)
As I sifted through the various preferred securities using these guidelines, two securities caught my attention.
From the insurance sector:
PRE-E: PartnerRe Ltd, 7.25% Series E Cumulative Redeemable Preferred Shares (callable 6/1/16; current yield to call 4.9%)
From the REIT sector:
PSA-O: Public Storage Inc., 6.875% Dep Shares Cumul Preferred Stock, Series O (callable 4/15/15; current yield to call 6.7%)
The yields for these securities compare to a current yield of 5.85% for PFF. Both securities are still selling at a premium to their liquidation/call prices of $25, so they still seem a little pricey to me (especially PRE-E). However, I am putting them on my watch list, and when interest rates move up enough that they start selling closer to par (or, better yet, at a discount), then I would seriously consider adding them to my income portfolio.
(Disclosure: I do not currently own any of the securities mentioned, but may purchase them in the future. All yields are calculated based on closing prices on 7/12/13. I am not recommending these securities as investments, only as potential securities for your own research. Please read the prospectuses for anything prior to making your own investments.)