Preferred stocks: high yields hiding in plain sight

Most income investors either trend toward bonds or dividend-paying stocks, completely forgetting that there’s a third option altogether in preferreds.

In many ways, preferred stocks combine the best of both worlds. Like common shares, they entail actual ownership interest in the companies in question. Like bonds, they tend to provide fixed income streams based on their face value, though – like common shares again – that’s through dividend payments.

Better yet, these yields can be significantly higher than what investors get from “regular” stock.

If that sounds more risky, it rarely is. Since companies can go public without offering preferred shares, most don’t. It tends to be well-established, “wide moat” businesses that go this route, such as banks, insurance companies, utilities, and real estate investment trusts (REITs).

They have the initial money to ensure preferred shares. So they then get to reap the resulting regulatory, accounting, and financing advantages.

When it comes to the foundation and even majority of my portfolio, I still opt for common shares. But I’m also a big fan of diversification, setting myself up for the best possible outcome whenever and wherever possible.

Knowing that, I’m always on the lookout for a good preferred opportunity. And once you understand how they operate, you might be, too.

Most people don’t understand preferred shares – if they know about them at all – because they don’t understand the corporate capital structure. Basically, companies fund themselves by:

If a company falls into financial distress or, worse yet, files for bankruptcy, debt holders get paid back first. Then come senior lenders and bondholders, hence the reason why the latter tend to be so reliable.

Common shareholders, however, are at the very bottom of the capital stack. Therefore, they tend to get nothing in these worst-case scenarios.

The reason why preferred shares are considered an “in between” option is because they are, in fact, in between. Anyone who owns them will find their claims still come after debt holders but before common shareholders. So they’re a safer stock play to hold.

Here’s another thing to like about preferred securities: Many of them can be classified as qualified dividend income (QDI). As such, they’re taxed at more long-term capital gains rates, which are less burdensome.

Far less burdensome, in fact.

For investors in the highest federal tax bracket, being able to claim QDI means paying 20% instead of 37% (plus the applicable 3.8% Medicare surtax). And for just about everyone else, it reduces rates from 35%, 32%, 24%, or 22% down to as little as 15%.

Interest income from corporate bonds and most common stocks, in comparison, is generally treated as ordinary income and therefore taxed as such.

Now, this isn’t a hard-and-fast rule. Tax considerations do vary by issuer and security. So I advise you to talk to an expert on the subject about any particular preferreds you want to buy – especially if tax breaks are your main reason for considering them.

However, overall, that perk combined with higher yields give investors meaningful advantages that are otherwise hard to come by.

Keep in mind, of course, that preferred stocks aren’t risk-free. No investment category ever is.

In this case, it’s mainly a matter of interest-rate sensitivity. Since the vast majority of preferreds pay fixed distributions, they often react to economic stimuli like bonds. So when interest rates rise…

Their share prices fall.

And when interest rates fall, their share prices rise. It’s just the name of the game.

Unlike bonds, however, preferred shares are perpetual securities in that they never mature. Technically, anyway.

Issuers do have the right to redeem, or call, their shares after a certain, specified date… which opens up another type of risk for anyone who buys these stocks above par (typically set at $25).

Investors can easily send them higher than that as they chase preferreds’ higher coupons. And if the company in question then redeems its shares, those left holding the bag still only get the initial $25 per share back.

That’s why it’s so important to look at what’s called “yield to call” information before you dive in. Otherwise, even the most attractive-looking payouts can end with disappointing total returns.

It’s just one more example of how valuation matters. Always.

There’s always a case to be made for buying up preferreds thanks to the reliable income they offer. But they can look even more attractive whenever common stocks are trading at elevated valuations – like many are now – and you already own enough bonds.

While there are plenty of worthwhile opportunities to explore within individual company offerings, several exchange-traded funds (ETFs) exist in this category as well. Two of my favorites are:

Virtus InfraCap is an actively managed ETF that seeks diversified exposure across the preferred securities market. It goes beyond simply tracking an index, with managers selecting its holdings based on credit quality, sector allocations, and issuer concentration.

In addition, the fund seeks to maximize yield-to-call by selling callable securities that trade above their par value before that risk becomes problematic. And it adjusts sector weightings according to relative value and credit quality along the way.

PFFR, meanwhile, focuses exclusively on U.S. REITs. Tracking the Index REIT Preferred Stock Index, it typically holds around 110 securities at a time, with its current top 10 being:

Would I buy up all of those REITs’ common stock? Definitely not. I don’t see much price appreciation possible at this time in names like Gladstone, for instance.

However, knowing that preferreds are safer and pay out differently – and often more prominently – than “regular” stocks keeps PFFR a top consideration in my book. Plus, while this particular ETF isn’t actively managed, it does employ a “smart beta” methodology that screens for liquidity, yield, and concentration limits.

As always, just like with valuation, quality matters. I’m not overlooking that factor here anymore than with PFFA. Not should you.

But I also wouldn’t ignore how adding exposure to preferreds can make a notable difference to what your portfolio can do. You could find yourself pleasantly surprised when you take the time to learn more about them.

Happy SWAN investing!

Brad Thomas
Editor, The Wide Moat Daily

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