Many investors are concerned that high yielding preferred shares will not perform well in a rising rate environment. I’ve heard from several readers who share these sentiments. Since April 1, ETFs like the PowerShares Preferred Portfolio (PGX) and the iShares S&P U.S. Preferred Stock Index Fund (PFF) are down 2% and 3.7% respectively.
These fears are overblown for a couple of reasons:
It’s unlikely that interest rates are going to rise high enough to make these yields unattractive in relative terms anytime soon.
These days, more preferred shares have floating rates anyway.
Not familiar with preferred shares? You’re not alone – most investors only consider “common” shares of stock when they look for income. These are the shares in a company you receive when you place an order with your broker online or over the phone. You probably know the problem with this approach – common shares in S&P 500 companies pay just 2.1% today, on average.
If you’re only considering common shares, then you’re settling for second-place in the shareholder return line. Many companies also issue preferred shares, which do indeed receive preferential treatment. Companies are actually obligated to pay their preferred shareholders first, even in the event of a bankruptcy. And many preferred shares pay a higher yield to boot.
They’re technically debt vehicles, like bonds. Preferreds usually pay a higher dividend rate than bonds – most pay between 5% and 7% today. As with other debt, companies issue preferreds when they need to raise additional capital.
Earlier this month, Wells Fargo (WFC) announced plans to offer $1 billion in preferreds with a 6% perpetual coupon. That’s more than double the stock’s current yield. If you’re looking for income, and you believe that Wells Fargo is in good financial shape, then the preferreds are an attractive income alternative to the common shares.
Many “first-level thinkers” want nothing to do with deals like these. They believe that preferred shares, like bonds, will get crushed in price when rates rise. So they’ve sold funds like PGX and PFF, which yield 6% as well.
They’re partly right – but they’re more wrong than right.
Their playbook is outdated by a decade. Today, more than 60% of preferred issues are fixed-to-float or floating-rate securities, versus less than 10% just ten years ago. These issues will not fall in price as much as fixed-for-life securities like the Wells perpetuals would during a rising rate environment, because their yields will reset higher as rates go up.
This doesn’t guarantee a smooth ride. But it means that a good portfolio manager can navigate a rising-rate tide by building a collection of coupons that always provide a “yield cushion” that’s higher than prevailing interest rates at any point in time.
Now I’m not recommending ETFs like PGX and PFF. I believe they’re leaving some alpha on the table and exposing investors to unnecessary credit risk. The only way you lose with this vehicle is by giving your money to a driver who crashes your car. But the S&P 500 and NASDAQ are large enough that there’s usually a company going bankrupt at any moment in time.
That’s why I recommend moving past a broad-based ETF in favor of a closed-end fund. You’ll have an active manager working for you, and if you buy when everyone hates the sector (like right now), you can purchase your shares at a 5-8% discount to the underlying Net Asset Value (NAV).
The “secret” system behind my Contrarian Income Report service has already led us to one closed-end preferred fund that pays 7.7%, and we’re adding another one to the portfolio this Friday that yields 8.7%. Both funds issue monthly dividends to boot. If you’re interested in reading my latest research and recommendations on preferred share funds, you can sign up to receive Friday’s issue right here.