Despite the attractiveness of their dividend yields, there are risks and limitations to what preferreds can do for a portfolio.
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To bolster investment yield, many credit unions hold preferred stocks as part of their employee benefits pre-funding portfolios, but preferred stocks aren’t for everyone, and credit unions should be leery about having these securities in their portfolio. Despite the attractiveness of their dividend yields, there are risks and limitations to what preferreds can do for a portfolio, and the high yields they offer aren’t sufficient to justify investing in these securities.
What Is a Preferred Stock?
Preferred stocks are a class of equities that sit between common stocks and bonds. Like stocks, they pay a dividend that the company is not contractually obligated to pay. Like bonds, their dividends are typically fixed and expressed as a percentage rate. Preferred shareholders receive preference over common stockholders, but in the case of a bankruptcy bond holders would be paid before preferred shareholders. Unlike common stock shareholders, who benefit from any growth in the value of a company, the return on preferred stocks is a function of the dividend yield.
It is the dividend yield that makes preferred stocks so alluring on the surface. As of Sept. 30, 2022, the 30-day yield on the iShares Preferred Stock Index Fund (PFF) was 5.11%, though the fund’s total return year-to-date through Sept. 30, 2022, is -17.13%.
Why Do Companies Issue Preferred Stocks?
Interest payments made to bondholders are tax deductible to the issuing corporation. Preferred stock dividend payments are not tax deductible to the issuing corporation. This makes issuing preferred stocks much more expensive for a company than issuing bonds.
Most companies with solid credit ratings don’t issue preferred stocks. Preferred stocks are generally too expensive a form of capital for strong credits. Why then, would a company issue preferred stock? The answers aren’t exactly reassuring.
A company might issue preferred shares if they are having trouble accessing other capital-raising options. Again, because it is cheaper for a company to issue bonds versus preferreds, a corporate treasurer may only resort to issuing preferreds if the company wants to have the flexibility to suspend dividend payments, is finding it difficult to find buyers for its debt, cannot find buyers for lower-dividend common stock, or would suffer a credit downgrade if additional debt obligations were added to its balance sheet.
Some companies issue preferred stock for regulatory reasons. For instance, regulators might limit the amount of debt a company is allowed to have outstanding. There may also be other regulatory reasons for issuing preferred stocks. In October 1996, for example, the Federal Reserve allowed U.S. bank holding companies to treat certain types of preferred stocks as Tier 1 capital.
Preferred stock dividends are paid at the discretion of the company and can be suspended at any time. Studies have found that about 6% of preferred-stock issuers defer or cancel dividend payments over a 10-year period. Conversely, bond interest payments are contractual obligations, and failure to pay bond interest payments is a serious offense and sets the wheels in motion for default and reorganization.
Who Owns Preferred Stocks?
The main buyers and holders of preferred stocks are corporations. This is because when a company receives a dividend payment from another company, the receiving company can deduct most of that dividend from its taxes, a benefit that is not available to individual investors. Since preferred shares usually have large dividend rates, corporations like to buy them, which leaves a rather small portion of the original issue available for outside investors. This makes preferred stocks less liquid than common stocks.
Credit Quality
While not all preferred stocks are in the junk-bond category, they seldom are highly rated credits. Consider the holdings of PFF as of Sept. 30, 2022. Only 2.5% were rated AAA (the highest investment grade), and only about 3.6% were rated A or higher.
Poor Performance in Times of Crisis
In a crisis, preferred stocks can be more volatile than common stocks. Preferred stocks’ performance in market downturns demonstrate that they come with much higher risk profiles than most income-generating securities. Aside from the technology correction in the early 2000s, when preferreds held up relatively well, preferred stocks have typically suffered double-digit losses during market drops. In 2008, for example, the ICE BofA Fixed Rate Preferred Total Return Index dropped more than -25%. When COVID roiled the markets in early 2020, preferred stocks lost about -23%, on average. And again, the iShares Preferred Stock Index Fund (PFF) is down over -17% year-to-date through Sept. 30, 2022.
Thanks in part to their poor performance during market drawdowns, preferred stocks have generally failed to generate high enough returns to offset their risks. Over the past 15 years, preferred stocks have shown about 94% of the volatility of stocks while generating lower returns than both investment-grade and high-yield bonds. As a result, Sharpe ratios for preferred stocks have lagged those of most other income-generating asset classes over the past 15 years.
Preferred stocks also present much greater exposure to default risk than even high-yield bonds. During the period 2003-2011, for example, which covers the period of the financial crisis, preferred stocks had about three times the exposure to default risk as 1-10 year high-yield bonds, and about twice that of 10-30 year high-yield bonds.
Call Provisions
Most preferred shares are “callable,” which means that the issuer has the right to buy them back at a pre-set price. This could happen if the company finds that it can sell cheaper conventional debt or common stock with a lower dividend. This call feature virtually eliminates the chance of a rally, because as an issuer’s outlook improves it is likely to repurchase those high-dividend preferred shares at a fixed price. On the other hand, there is little to prevent preferreds from sinking if the issuer runs into difficulties and needs to cut dividends. The result is a non-symmetrical return pattern where the upside is capped but the downside is not. Said another way, the investor has the risk of a long-duration product when rates rise, but the call feature puts a lid on returns if rates fall. Thus, preferred stocks rarely trade much above their issue price. Because almost all callable preferred stocks are callable at par, there’s extremely limited upside potential if the security is purchased at par, and virtually no upside if the call date is near.
Preferred stocks are complex and come with a very distinctive set of risks and limitation. Credit unions and individual investors alike, would be wise to look elsewhere in their quest for income.
Matthew Butler
Matthew Butler is the Founder and Managing Principal of Elite Capital Management Group, LLC in Cheshire, Conn.
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