Finding niches with higher income

Why preferred stocks could offer higher dividends, good value, and possible tax benefits.

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Investors seeking to put new money to work in the market this year may be at a crossroads, given a price run-up in many cyclical names since early 2020 and concerns that investment-grade bonds could offer low returns due to tight credit spreads and historically low yields.

"This is why I like overlooked niches of the market that I believe offer good value and relatively higher dividends, and I've found this combination in preferred stocks," says Adam Kramer, co-manager of Fidelity Preferred Securities & Income ETF (FPFD).

Working with Co-Manager Brian Chang, Kramer seeks high total return and normally invests at least 80% of the fund's assets in preferred stocks and other income-producing securities that sit above common equity in a company's capital structure, but below senior debt. Many of the fund's investments are backed by well-known financial and utilities companies and real estate investment trusts (REITs), Kramer says.

Preferreds offer both stock- and bond-like qualities, according to Kramer. They tend to pay a set schedule of dividend payments to investors and offer the potential for price appreciation over time.

Also, the interest investors receive from preferred stocks may be taxed at a lower rate than bond dividends. Investors generally pay no capital gains on individual portfolio securities.

Kramer and Chang seek to add preferred securities exposure to the fund when the option-adjusted spread of preferreds rises above that of investment-grade bonds, which Kramer says is the case as of late. When this happens, Kramer says, it can be an opportunity to earn relatively higher yields with less duration risk than investment-grade bonds, since many preferreds are callable after five years. He says this limits their upside, but also their downside.

It's possible for companies to pull dividend payments from preferred stocks if they face financial hardships, Kramer notes, and it's one of the risks of investing in the asset class.

For this reason, he says Fidelity's in-depth credit research guides the fund's investments. He targets securities rated just below investment grade and above, choosing carefully from among lower-rated issues.

"I find preferreds to be a less popular asset class that's not as heavily researched as stocks and investment-grade bonds, which provides our team opportunities to find value-priced, misunderstood offerings," Kramer says.

Kramer also explains that preferred securities held in the ETF may pay dividends at a fixed rate, floating rate, or a combination of both. He often invests part of the fund's assets in securities with floating rate dividends, which rise if policy interest rates move higher, thus helping to guard against the possibility of rate inflation.

"I think this is an attractive asset class," Kramer says. "We've been able to find preferred securities that in some cases pay yields of 5% or more at fair prices, backed by company fundamentals we really like."

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