CHICAGO, Aug 20 (Reuters) - Frustrated yield seekers have
been drawn to preferred stocks because they offer a
several-point yield advantage over most U.S. investment grade
bonds, including Treasuries, corporates and municipal bonds.
But these quasi-stock, quasi-bond investments act like bonds
when interest rates rise: They fall in value. That has brought
them some negative attention in the last few months. Preferred
stocks declined in value as investors scrambled to find
higher-yielding vehicles when rates rose. They may now may be
oversold and offer some bargains.
Preferreds straddle a territory between common stocks and
bonds. Mostly issued by financial companies, preferred stocks
confer no voting rights, but represent a higher claim on
earnings than common stocks, and are less volatile.
They also best the stock market's dividend yield by a hefty
amount: The Standard & Poor's 500 stock index has a 2.01
percent dividend yield, while an exchange traded fund that holds
the preferred shares of the same companies is yielding 5.78
In the event of a company's liquidation, preferred
stockholders are second in line for corporate assets, behind
bond investors. Buying a pool of preferreds through
exchange-traded funds can help you mitigate that risk.
The largest preferred-stock exchange-traded fund - the $10
billion iShares S&P Preferred Stock Index - lost nearly
7 percent in the three months through Aug. 16. It charges 0.48
percent annually for management expenses, and holds shares from
megabanks such as Barclays Bank plc, Citigroup
and Wells Fargo & Co.
Due to its nearly 6 percent yield, the iShares fund still
keeps you slightly ahead of the bond market's recent volatility.
It's up 0.25 percent over the 12 months through Aug. 16. By
comparison, the Barclays U.S. Aggregate Bond Total Return Index,
a benchmark for the U.S. bond market, which is down nearly 2
"The main issue with preferred stocks is interest-rate
risk," says Eric Dutram, an analyst with Zacks Investment
Research in Chicago. "There's no way around it."
MORE DIVERSIFIED ALTERNATIVES
Still, it's vexing to see a high-yield stock track the bond
market. In a perfect world, that wouldn't happen and a preferred
stock would offer a diversified option to high-yield bonds.
One way to sidestep some of the volatility is to invest in
preferreds outside of U.S. financial services, which have been
soaring over the past year. The sector has rebounded strongly
from the post-2008 selloff and is up more than 32 percent in the
12 months ending Aug. 16, but may have run its course.
A worthy option is the Global X SuperIncome Preferred ETF
, which holds non-U.S. companies such as HSBC Holdings,
plc, Royal Bank of Scotland Group plc and
Lloyds Banking Group plc. The fund is up almost 4
percent for the 12 months through Aug. 16 and yields nearly 7
percent. It also costs more to manage: 0.65 percent annually.
Keep in mind that preferreds have yet another advantage that
somewhat offsets their close correlation to bonds: They are less
volatile than common stocks. When the S&P 500 fell 37 percent in
2008, for example, the iShares preferred fund fell only 24
That doesn't mean you should gorge on the high yields that
preferreds offer and abandon common stocks. Preferred funds are
heavily concentrated in the financial sector, which adds another
layer of diversification risk. You can always buy individual
preferred issues, but they are complicated to analyze, so you
may want to use an experienced adviser who knows how to buy them
at a good price.
You'll still need to balance out the income side of your
portfolio with vehicles such as municipal, government and
corporate bonds and real estate investment trusts.
Every one of these investments can lose value in a
rising-rate environment, so they may still hold some nasty
surprises if the economy keeps heating up and the Federal
Reserve starts to back off its monetary easing policy.
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