A 'Preferred' Way to Generate Income

11/24/2014 10:00 am EST

Focus: STOCKS

Combining qualities of both stocks and bonds, preferreds offer investors the chance for 6% yields, according to Carolyn Bigda of Kiplinger's Personal Finance magazine. Here, she explains these vehicles and highlights some favorite issues.

Steven Halpern:  Joining us today is Carolyn Bigda of Kiplinger's Personal Finance Magazine.  How are you doing today, Carolyn?

Carolyn Bigda:  I'm well, thanks.

Steven Halpern:  Well, thank you for joining us.  Today, we're going to talk about preferred stocks, which offer the features of both stocks and bonds.  Could you explain to our listeners who aren't familiar with these securities?

Carolyn Bigda:  Sure.  We say that they have features like stocks and bonds because, like stocks, preferreds give you an equity stake in a company, and their dividends often qualify for the long-term capital gains tax rate, which maxes out at 23.8% today.

But, like bonds, a preferred stock distributes a fixed amount of income, a dividend, and get repaid at their par value, which normally is $25 per share.

Steven Halpern:  Now, you point out that one catch in this situation is that preferreds have no fixed maturity date or they come due far in the future.  Could you expand on that?

Carolyn Bigda:  Because of that feature then, the preferred stocks are going to perform a little bit like bonds, meaning that their share prices move up and down with changes and long-term interest rates.

And so, as you mentioned, they don't often have a maturity date, or that maturity date is far into the future. ut companies that issue preferred stocks, they do have an option to call or pay off a preferred after a set period. 

That's usually five years from the date of issue, but when interest rates are rising, issuers are a lot less likely to call those bonds, because why would they pay a higher interest rate on the preferred stock. 

As a result, when the interest rates are rising, the sensitivity of a preferred stock to interest rate movement starts to grow, and then you can see through your losses in that case.

Steven Halpern:  Now, you note that the S&P Preferred Stock Index yields around 6.5%, which is almost triple the yield of the 10-year treasury bond, yet as attractive as that may seem on the surface, you caution investors not to put more than 10% of their fixed income assets into this area.  Could you explain some of the risks involved?

Carolyn Bigda:  The yield on the S&P US Preferred Stock Index is very tempting.  It's around 6% today, but you do want to be a bit cautious, because, for one, most preferreds are issued by financial institutions, so you don't want to load up on these, because that means you'd be loading up on one sector. 

Utilities and telecoms do issue preferreds, but the vast majority of these stocks are issued by banks and insurers and so forth, so, you don't want to get too over concentrated in one sector. 

Also keep in mind that companies can cut or suspend a preferred dividend without notice, so there's no guarantee that you're going to be getting this payout from your preferred stock forever.

Steven Halpern:  Now, one of the preferreds that you highlight in your recent article for Kiplinger's Personal Finance is the Goldman Sachs Series I (GSF).  Could you share your thoughts on that?

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Carolyn Bigda:  Sure.  Goldman Sachs, when we were looking for examples to consider, we were looking for mostly financial institutions that had stronger balance sheets, that business is rebounding, and Goldman Sachs is one of those. 

We were also looking for preferreds that were trading below par, so there was a little bit of wiggle room if interest rates did start to go up, so that was why we picked out this preferred stock, because at the time when we wrote the story, it was priced at just over $24, and it was yielding about 6.2%, so a fairly attractive proposition there.

Steven Halpern:  Now, you also point to a preferred issued by another financial firm, BB&T Corp. Series D (BBT-PD).  What's the attraction there?

Carolyn Bigda:  Sort of the same logic applies with this preferred stock.  Again, it was trading below par, had a yield of about 6% and comes from, again, a pretty financially sound bank.

Steven Halpern:  Now, to hedge against rising interest rates, you also mention that it's possible to buy what are called fixed-to-floating rate preferreds, and one issue there you highlight is US Bancorp Series F (Non-Cumulative Perpetual Preferred).  Could you explain this investment vehicle?

Carolyn Bigda:  Sure.  These are, like you mentioned, kind of a hedge against rising interest rates. 

With these, you earn a fixed payout for a set period, ordinarily about ten years, and then, after that, the dividend's going to adjust along with the benchmark, normally the LIBOR benchmark, or the London Interbank Offered Rate, and so that's the case with this one.  It's a little bit expensive. 

It trades and, again, with this story it was trading at more than par and yielding about 5.6%, but it didn't have that option to switch to the floating rate until 2022, so that gives you quite a few years of a high payout.

And then, at that point, the interest rate is benchmarked or tied to the three-month LIBOR rate, and so, if interest rates had gone up at that point, you'd have a little bit of protection against that, essentially, with this preferred.

Steven Halpern:  Now finally, for those interested in preferreds but who would prefer a more diversified portfolio rather than the risks of selecting a particular issue, you point to an ETF in the sector called the iShares S&P US Preferred Stock ETF (PFF).  Could you tell our listeners about this option?

Carolyn Bigda:  Sure.  We highlighted ETFs because a lot of the mutual funds in this space, they charge a sales load to invest in them, or they have high minimum initial investments, so those are the reasons why we like the ETF option with preferred stocks.

We like iShares US Preferred Stock ETF, because it charges some of the lowest fees among its peers and has had a fairly good performance recently and is also pretty well diversified in this area.  It holds a lot of preferred stocks, so you're getting good diversification for a pretty low cost.

Steven Halpern:  Again, our guest is Carolyn Bigda of Kiplinger's Personal Finance Magazine.  Thank you so much for joining us today.

Carolyn Bigda:  My pleasure.

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