A preference for yield: Investng in preferreds
"Preferred stock has been much in the news over the past 18 months, primarily as the favorite way for cash-strapped banks to raise capital," says Mark Salzinger.
In The Investor's ETF Report, he says, "These unusual securities are popular because they offer high yields and have a higher position in corporate credit structure than common stock." Here, he offers a pair of favored ETFs that invest in preferred shares.
"We caution that preferred stocks also have significant drawbacks that dampen their appeal. Apreferred stock is really more like a fixed-income instrument than an equity security.
"Many preferred stocks have a maturity date, and all pay dividends of a set amount each year. Therefore many are not eligible for the 15% tax rate on 'Qualified' dividends; their dividends are taxed as ordinary income, just like the interest on bonds.
"Unlike common stock dividends, preferred stock dividends generally do not increase over time at the discretion of the company.
"Preferred stock dividends are sheltered more than common stock dividends. Companies must pay dividends on preferred stock before dividends on common stock. If a common stock dividend is reduced or eliminated, the company still owes those on preferred stock.
"Despite this preferential positioning, preferred stocks are still quite low in the pecking order behind a company’s creditors— all of them, not just the secured creditors. Neither do preferred stocks have the covenants that protect and govern conditions and terms of payment to bondholders.
"Why would anyone want to own preferred stocks then? Simply, they have high yields, almost always significantly higher than yields on common stock.
"Some companies would rather issue preferred stock than bonds because it expands their capital base without increasing their debt burden. To entice investors to buy these unusual instruments that work like bonds but lack their security, they have to offer higher yields.
"Preferred stock has bounced strongly off the March market lows. Financial-services companies have been the most prolific issuers of preferred shares, and preferred stock ETFs are a way to earn a fat yield and bet on a turnaround for the sector.
"Both iShares S&PUS Preferred Stock (NYSE: PFF) and PowerShares Preferred (NYSE: PGX) invest in about 70 of the largest and most heavily traded preferred stocks.
"Financials dominate each portfolio, accounting for more than 80% of each. Yields are high: PFF recently yielded 8.4%, PGX 8.8%. They even have similar expense ratios (0.48% for PFF, 0.50% for PGX).
"The biggest differences are in foreign holdings and average credit quality. iShares S&PUS Preferred Stock invests only in U.S. preferred stocks, while PowerShares Preferred also invests in foreign issues.
"This subjects the latter ETF to foreign-currency fluctuations but better reflects the global market for preferred shares.
"But PowerShares Preferred is limited to preferred stocks with investment-grade credit ratings at the time of purchase. Its average credit rating is BBB+, vs. BB- (which is below investment grade) for the iShares offering.
"Many of the lower credit ratings come from preferred stocks whose credit ratings have been downgraded over the past year.
"With so many similarities, we are inclined to favor iShares S&PUS Preferred because it has a larger asset base and has a higher trading volume.
"This will help keep bid/ask spreads tighter and in turn keep its share price more closely aligned with its net asset value, an important trait in a product that invests primarily in generally misunderstood assets from an out-of-favor sector."
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