An investment that lies somewhere between bonds and common stock is racing higher, the latest example of a bet that is flourishing in a world where yield is scarce.
Preferred stock typically offers investors heftier payouts than U.S. Treasurys and more safety than traditional common shares, since owners of preferred stock get priority whenever a company goes bust and distributes its assets.
That combination has made the nearly $500 billion market irresistible for many yield-seeking investors—though analysts and portfolio managers warn not to get carried away with these investments, which come with significant limitations.
The Invesco Preferred ETF (PGX), one of the largest exchange-traded funds that tracks the group, is up 12% in 2019. That puts it on course for its biggest one-year gain since its launch in 2008. Although the fund has trailed the S&P 500’s (.SPX) 19% gain, it has easily outperformed investment-grade bonds. The iShares Core U.S. Aggregate Bond ETF (AGG) has risen 6.3% in 2019.
“If you think we’re going to be in a low-rate environment for an extended period of time, higher-yielding securities are going to be more sought after,” said Brian Rehling, co-head of global fixed-income strategy for Wells Fargo Investment Institute.
Despite its banner year, preferred stock carries pitfalls that Mr. Rehling and others warn could may make its gains fleeting. Among the biggest: Preferred stock offers neither the security of debt issued by a company, which is higher up in the capital structure, nor the potential upside of common stock.
JPMorgan Chase & Co. (JPM), for instance, offers preferred stock with a dividend rate of 6%. (With preferred stock, like a bond, the payout rate is fixed. But its yield, or the annual dividend divided by the current price, can fluctuate.) That is more generous than the yield on the 10-year U.S. Treasury note, which settled Monday at 1.675%, and the dividend yield on the S&P 500, which is around 2%.
But someone holding JPMorgan’s preferred stock right now would find their returns are easily eclipsed by someone holding JPMorgan’s common stock, which has climbed 21% this year.
That is because investors make a trade-off when buying preferred stock. Although they can count on reaping income from dividend payouts, the price of the security itself typically doesn’t stray too far above or below its so-called par value, even if a company’s profits look poised to soar. (Preferred stock is normally issued with a par value of either $25 or $1,000.) The ownership of the company rests with holders of common, not preferred, stock.
“You don’t participate in the upside of the company,” Mr. Rehling said.
A less commonly realized, but still relevant, drawback involves what happens to an investor if a company must liquidate. If a company were to go under, it would be legally obligated to pay off its bondholders first, then holders of preferred stock, and finally, common stockholders. Struggling companies also can suspend their dividend payments, negating preferred stock’s main attraction.
“You have to look at the worst-case scenario,” said Ken Stern, senior managing director of Lido Advisors, recalling the collapse of the group in the 2008-09 financial crisis.Mr. Stern advises clients to be wary of scooping up preferred stock simply based on its dividend yield, cautioning that something issued by a small and highly debt-laden real-estate investment trust, for instance, isn’t comparable in quality with something issued by a multinational bank. “Chasing yield blindly is never a good thing,” he added.
Then there is the fact that the size of the preferred-stock market still pales in comparison with the broader stock market. As is the case with other relatively small markets, preferred stock—which many investors access through ETFs—can be particularly susceptible to volatility, despite the relative stability of their holdings.
“ETFs are so large and lethargic in the way they transact that when there’s panic and investors want their money out, the only way to do so is to sell, and they sell aggressively,” said Allen Hassan, managing director and head of preferred-stock trading at Ziegler Capital Markets.
When fears of slowing growth and worsening trade tensions sent markets tumbling in the fourth quarter of 2018, for instance, the Invesco Preferred ETF fell 5.9% for its biggest quarterly decline in two years.
To be sure, few are convinced the U.S. is on the cusp of an economic downturn. And so far, the scarcity of readily available yield across the investment universe has made preferred stock look more attractive to investors than it has in some time.
Just don’t count on the scale of its outperformance lasting, analysts say.
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