How to play preferred stock as yields rise

  • By Andrew Bary,
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If you are searching for yield, you should now be looking at preferred stock.

Yields on many preferred issues have risen a half-percentage point or more in the past month, as investors have sold off Treasuries and exited from some exchange-traded preferred funds.

Preferreds from bank issuers like Bank of America (BAC) and JPMorgan Chase (JPM) are yielding close to 6%. Some preferred issues from real estate investment trusts have yields of around 7%. Closed-end funds specializing in preferred have come under pressure lately, and some trade at nearly double-digit discounts to their net asset values. Yields are in the 8% range.

The largest ETF, the $15 billion iShares U.S. Preferred Stock (PFF), trades around $36, near its 52-week low, and yields 5.7%. Preferred issues have littered the New York Stock Exchange new-lows list lately.

“We’re incredibly constructive on the market now,” says Doug Baker, head of the preferred sector group at Nuveen, which runs about $8 billion of preferred investments, including several closed-end funds like Nuveen Preferred & Income Opportunities fund (JPC).

One reason for Baker’s optimism is a widening yield gap between bank preferred and Treasury securities this year even as bank credit-quality improves. Banks account for more than half the $350 billion domestic preferred market.

Credit quality is important because preferred is a senior form of equity and thus is more vulnerable than debt to financial stress. Companies can decide not to pay preferred dividends without the actions treated as defaults. As a result, credit ratings on preferreds are usually several notches below those on bonds.

Still, corporations take preferred dividends seriously. They generally can’t pay common stock dividends without paying preferred holders theirs.

Retail buyers like the lofty yields and more favorable tax treatment of preferred relative to high-grade corporate bonds.

Most preferred dividends—including those from banks—are treated like common-stock dividends and are subject to the preferential 20% top tax rate. Preferreds offer an alternative to long-term municipal bonds, now yielding 3.5% to 4.5% (depending on credit quality), and junk bonds, now yielding an average of about 6%.

REIT preferreds don’t benefit from the preferential dividend tax rate and usually are subject to a top rate of 29.6%. Investors pay their marginal income-tax rate, but they can deduct 20% of their REIT dividends from their taxes.

“Thus, only 80% of the dividends derived from a REIT are taxable,” says New York tax expert Robert Willens. “Using a maximum rate of 37%, this translates into an ‘effective’ tax rate imposed on REIT dividends of 29.6%.”

Liquidity is also better with preferred since most trade on the NYSE compared with the more opaque market for corporate bonds. Many preferreds are sold at a $25 face value to appeal to retail buyers. Those aimed at institutions usually have a face value of $1,000.

Preferreds generally carry fixed dividends and no or very long maturity dates. This makes preferred equivalent to an ultralong-term bond and therefore sensitive to changes in long-term rates. The problem for investors is that issuers typically can redeem—or call—preferreds five years after issuance, resulting in limited upside and considerable downside.

It pays to buy preferreds trading at a discount or at a small premium to face value, providing holders greater upside potential. When preferreds trade above par, or face value, yields are calculated based on the call date generally within five years. It pays to be careful about premium-priced preferred because yields have been negative at times, Baker says.

To avoid such pitfalls, active management may make more sense than passive strategies. One benefit of preferred-stock mutual funds is that managers can better access the $1,000 institutional preferred market, where yields often are better than in the $25 retail preferred market.

One large and unusual preferred issue is the $4 billion Wells Fargo series L. It carries a lofty dividend rate of 7.5%, trades around $1,260, a big premium to face value of $1,000, and yields about 6%.

It’s a favorite of David King, co-manager of the Columbia Flexible Capital Income fund (CFIAX). “I can see why it confuses people but it’s a better instrument to own than traditional preferred.” This convertible issue can be called only if Wells Fargo (WFC) common stock, now around $53, hits $156 and then at an effective 30% premium to its face value. This gives the issue considerable call protection. Bank of America has a preferred with a similar structure, its series L.

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