Because of the substantial decrease in payout from bonds and CD''s I have been investigating Preferred stocks as a source of income at Quantumonline.com.

However I am puzzled that some of the issues with good credit ratings are paying in excess of 7% which is considerably more than bonds or CD's are currently paying.

Am I missing something?  Is there a downside to these type of stocks that does not exist in other fixed income investments.

Any suggestions, advice or selections you may wish to share would be greatly appreciated.

                                  Thanks

Its important not to think of Preferred Stock and MM accounts as equivalent, which is what tends to happen when you compare their yields.

Preferred stock have distinctive risks, which include:

- illiquidity risk

- interest rate risk

- perpetuity risk

- redemption and reinvestment risk

- default/dividend discontinuation risk

Each of these risks should carry with them an expected premium to a risk-free government bond. This 'cummulative risk premium' is a bit difficult to quantify, But generally for an investment grade preferred I'd expect 450 - 500 bp premium to the current 3.6% T-Note or about an 8.25 - 8.75 yield on the preferred stock.

Others may have a different method, but this is how I approach it

BruceM

Yes, there is more risk in a preferred stock than in a bond.

First of all, the issuing company can suspend the dividend payment on a preferred and continue as an operating concern... without being in default. Also, most preferreds are non-cumulative, which means that the issuing company has no obligation to make up missed payments in the future.

Secondly, if a company is forced to reorgainze, preferred shareholders stand in line behind all of the debtholders (but in front of the common shareholders).

And finally, preferred shares typically have no maturity date, so there is considerable inflation risk associated with these securities. If inflation and interest rates go up significantly, the share price of your preferreds will decline, and you may be stuck with a low-interest-rate security in perpetuity.

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Now, with all of that said, I think there is a place for preferreds in a portfolio, but I don't consider them a "core" holding.

Also, you will see "trust preferreds" trading on the exchanges. These are backed by debt, so they are safer than an ordinary preferred issued by the same company. Since they're backed by debt, they do have a maturity date, although they are generally very long-term instruments.

Regards,

Duane

....the long term odds favor the issuer, not the investor. If rates go down, they'll call them, leaving you with a pile of cash to reinvest at a lower rate. If rates go up, you are stuck with the lower rate (into perpetuity in the case of the Barclay's 8% Prr'd, I just got an email about). You are making long term interest bets against people who are smarter than you are.

A boring non-callable bond has no surprises (and a lower coupon rate). Sometimes you want a little boredom to go with your security. I personally do not feel able to suss out the way interest ways are going and so follow a bond ladder strategy.

And I wonder just how preffered most preffereds really are. The promise to get paid before the common stock holders may not be much consolation if the company nosedives ala Bear Stearns. You'll also want to read the fine print. The Barclays issue above reserves the right to defer coupon payments for 40 quarters if times get rough. That's a decade-long wait for your money, potentially.

Larry Swedroe's book, "The Winning Bond Strategy" makes a good case against preffereds and I highly recommend it for a conservative approach to fixed income investing. He's not (no one is) the last word, but his book was very compelling. 

 

 

kittydog2,

You make some very good points. Preferreds are not without risk.

For what it's worth, there are also debt securities that trade on the exchanges, much as preferred stocks trade. They're typically issued at 25/sh, although some are issued at differrent prices. They are easy to buy and sell, just as with a common stock. From an individual investor's point of view some are very liquid, with average trading volume in the hundreds of thouands of shares. Others, however, are very thinly traded (even seeing days with no trading for some issues).

Again, these are typically long-term maturities, and callable, so they suffer the same "rates fall, you lose; rates rise, you lose" problem. One can buy an issue that's trading below par and get a little protection against falling rates, though.

Regards,

Duane

It seems that every other day I am getting an offering for something paying 8% in perpetuity from a bank rated 3 *'s by Morningstar with the ominous bit in the fiancial health section about how Tier 1 levels of coverage are fine (AT THE MOMENT), but that conditions may deteriorate.

Anyone reading my posts will easily glean that I am a mid-level novice investor compared to most people here, but I still have to wonder:

Why are the banks giving me 8% with a lot of headachey add-ons and giving sovereign wealth funds 11% with less onerous restrictions and probably a nice lunch out as well?

Instinctively, I think it may be because yield-hungry light weights like myself have less knowledge and clout. But that doesn't mean we need to jump at every cookie. 

 

i own several preferreds and sleep well at night.  Have had a problem with a few (see my messages in the CEF board) but things have usually worked out. Duane raises a good point.  Instead of looking at traditional preferreds go to Quantumonline and look at trust preferreds. The trust usually buys company debt with the money they make selling  preferreds.  if the debt is called or the firm goes belly up then whatever receipts the holdings get from the sale of the debt (subordinated or unsubordinated)  goes to the preferred holders.Last i looked Bear Stern's trust preferreds are carrying an investment grade rating and paying 8% which is pretty much in line with other financials.

Hey Gerry, I'd like to sleep well at night too. Can you recommend some preferreds that you like or own?

Thanks,

Dick

Goood Afternoon Dick.

A couple i am looking at right now are Bear Stern offerings.  Think they are pretty safe since JPM stepped in to the picture. They are BSC-x which is a capital trust preferred and BSC-e which is a traditional preferred.  I've underlined the difference  cause I'm of the opinion that this difference could be important in order of payment if things go badly south. The assets backing the trust preferreds in this instance is junior subordinated debt. In my opinion (and I have not checked this out) these preferreds will be paid prior to traditional preferreds, since jr debt  has a higher priority than preferred stock. The prospectus states that if the debt is retired the proceeds must go first to the preferred stock of the "trust" and then to the common stock of the "trust".  So you are investing in a trust which holds only Bear Stern's debt, and not in Bear Stern's itself. From some of the postings on these boards i get the impression that some posters may not be aware of the difference.

Bear is paying 6.15% on the BSCprE vs 7.8% on the BSCprX so I assume the "X" will be called before the "E".  "E" is a traditional preferred and carries a lower rating BBB+ vs "X" which carries A-.  Both are paying in the neighborhood of 8%.  But  "E"'s market price is $38.60 for a 20% discount vs "X"'s price which offers only a 3.5% discount.  Both are nice kickers if called but paying $38.6 for a $50 payout is better than $24.13 for a $25 payout.Both ratings were issued in late 07 after the rating scandal hit the front pages. So i think both ratings are probably somewhat conservative compared to earlier issued ratings.

I am also looking at FRE and FNM fixed-floating traditional non-cumulative preferreds.  I love the terms.

Since most companies issuing preferreds are those who need large amounts of capital,e.g., financial, insurance and utilities with a minimal impact on the balance sheet I hate to go overboard on preferreds since I am getting real heavy in financials. So I'm holding back and reviewing further.

Only my opinion of course but that's my thinking as of this moment

 

Thanks for the input Gerry. I'll f/u w/ these & see where they fit.

Appreciate the response.

Dick

Friday's (April 25) Wall Street Journal had an article about the pros & cons of preferred stocks, which I felt was informative.  A few days ago I purchased Fannie Mae's recently issued FNMprS yielding 8.28%.  I am hoping that if things go bad, and I don't expect they will, that the federal government will step in and bail it out...but who knows for sure? 

Has anyone sold a preferred?  I've had a couple for a number of years and have wondered how hard it is to sell them. Their values do change so I assume there is some liquidity.

Knobby 

frank4914,

Any suggestions, advice or selections you may wish to share would be greatly appreciated.

I am using the PowerShares Financial Preferred ETF (PGF). It is limited to investment grade issues that are qualified for the lower qualified dividend tax. i-Shares also has a preferred ETF (PFF) which is more diversified and not limited to qualified dividend tax issues.

Anyway, you may not want to lose any return paying the expense ratio of an ETF, but I thought I would mention them just in case you weren't aware they existed. They both should be less risky than any individual preferred...but of course that comes with a pricetag  :)

-dale 

 

Depends on the issue - some are thinly traded and may take awhile to sell or you may not get your price. Stick to one's with significant volume.

-tony

Hi All,

I have been reading these posts from some very smart, informed investors.......I do think, however, People are putting wayyyyy too much thought into these investments than they merit. In the long run the simpler may just be the better. An example.......

BAC-B issued by Bank of America (BAC- rated AA) which I bought at just around $23.00.  It's not at the tax reduced 15% but so what? Preferreds should IMHO be a very small part of any investor's income portfolio. It is callable in 2011. So for every 100 shares bought I am feeling safe with a MINIMUM return of 8.6%  for the next three years in capital appreciation alone! Not even counting payments of 6.6  percent annualy for the next three years. Granted, My payments will not grow or combat inflation but at that return/risk level my head hits that pillow much easier these days.

Same Goes for U.S. Bancorp Preferreds. (USB-J in particular AA rated as well- callable in 2011). You hold for duration untill that year and you have very little (if none) worries they will suspend or default in quarterly payments. (I just know USB keeps raising their dividends year after year and I have a long term investment in their common shares.)

If all of this intimidates some then be rest assured many of your CEF's concentrate or diversify in these issues as well...So you can let your CEF fees pay for themselves trusting it to the pro's who get better rates than God on these things just simply by owning your preferreds through them.  

 As for an earlier statement made above here....."You are "called" and then left with a bundle of cash to reinvest at lower rates". Why lower rates? Who makes that rule? With research and instinct perhaps your portfolio objectives have changed in a few years, or you might want the cash....Or you have a diversifier you have been waiting on for years. Who knows? Each investor applies what we read and type and incorporates it into his/her own portfolio...   

So at the end of the day it comes down to this.....If you're going to buy a preferred , or individual bond buy it well below it's "callable value" and lock in gains no matter when the call date. Take the quarterly payments with assurance that you have invested in a quality firm....Not a Mortgage Reit with a BB rating. At the very most I would never put more than 10% into individual  preferreds for the simple reason you actually have more than you think if you are in income producing CEF's(REIT, DIV. funds).

Mariner.....

" As for an earlier statement made above here....."You are "called" and then left with a bundle of cash to reinvest at lower rates". Why lower rates? Who makes that rule?"

The market makes that rule.

The OP's point is that when interest rate's drop to the point that its cheaper for the issuer of the preferred to redeem (not call) the preferred stock and then reissue it at a lower rate, then as a redeemed former shareholder, you're out on the street with your $25/share, a capital gains tax bill (assuming you bought them for less than $25/share) and a much lower interest rate environment to now reinvest (reinvestment risk). This generally means that you will take a net cut in your dividend as a result of the redemption. So to the issuer its 'heads I win, tails you lose'.

Now, don't get me wrong, I've held tens of preferreds over the years and enjoyed their higher dividends while I've owned them. But for most, as interest rates decline, redemption is likely inevitable.

BruceM

Preferreds are thinly traded but can be sold. I buy preferreds that are discounted from the usual redemption value of $25, have coupons of 7% or lower since they are less likely to be redeemed. I am interested in permanent income streams with little or no interest in liquidating or selling them. I own BAC-E, PSA-M, UDR-G, HPT and HRP preferreds, SKT-C, AMB(all yield above 7%). These are all strong investment grade companies with the chances of them omitting the preferred virtually nil and are unlikely to have their ability to raise capital significantly affected. The only real risk in these is, like most income producing vehicles, can move downward with risiing interest rates(what doesn't?). You aren't really missing something...it is just that yields of these preferreds have moved upward because of the volatility of the credit markets and one must differentiate the good preferreds from the not so good.

Is right now the wrost time to buy a preferred stock? Bernanke says Fed won't likely to cut rates further. There really isn't much room to cut and currently the economy is facing quite a high inflation. Since preferred stock is usually a long term investment, my feeling is that in general, it is risky to invest in a preferred stock right now.

On the other hand, there are a hand full of preferred stocks from major commerical investment banks with coupon of 7.8 to 8.6% and yield aound 7.5-8.52%. Obvously, interest premium is due to the financial crisis and these preferreds are not without risks.

How would you guys weight the risks and rewards?