There has been a lot of talk in the investing community lately about when interest rates will start to rise. Indeed in several of my past articles, when I have discussed bonds paying high yields (for example here), I invariably get a comment or two saying that buying bonds now is foolish because of the interest rate risk.
So for investors looking to stocks instead of bonds, that leaves limited options. Either you invest in high yielding stocks like R.R. Donnelley (NASDAQ:RRD), Pitney Bowes (NYSE:PBI), and Windstream (NASDAQ:WIN) and assume this high risk of a dividend cut with these firms, or you invest in more reliable companies where prices have gone up so much that yields are historically low like Pfizer (NYSE:PFE), Duke (NYSE:DUK), and Coca-Cola (NYSE:KO). Call me crazy, but none of these choices for investors seem all that appealing to me… interest rate risk with bonds, dividend cut risk with riskier companies, or low yields and price risk with safer companies.
However, there is an alternative which many investors could benefit from; preferred stocks. Now if you think back to your college Finance 101 class you will remember that in the event of a bankruptcy, bondholders get paid first, followed by preferred stock holders, and finally common stock holders. Further, while common stock dividends get cut all the time, preferred stock dividends are cut much more rarely, and when preferred stock dividends are cut those cuts have to be made up in full in the future before any additional common stock dividends can be paid. For this reason, investing legend Ben Graham (erstwhile mentor to Warren Buffett) advocated strongly in his books that investors put their money into preferred stocks.
Preferred stocks have lost a lot of luster in the investment community since Graham's day, and you won't find them mentioned in the financial press much anymore. This is perhaps because of the benefits to common stock; common stock holders usually garner the lion's share of increased profits, while preferred dividend stockholders and bond holders are generally stuck with whatever their investment started out paying. (The exception being for participating preferred stock. This is a very special case where preferred stock dividends rise as firm profits do.)
Additionally, because of the great protection afforded to preferred stockholders, preferred stock tends to rise and fall in value much more slowly than the common stock of the associated company. A case in point would be Molycorp (NYSE:MCP). While the common stock of the premier rare earth miner in the western hemisphere has fallen from $30 a share about a year ago to around $5 today, the preferred stock has only fallen from $65 to $20 or so. While this is still a terrible stock decline, it is a lot better than it could have been. And for those who believe in the long-term prospects of Molycorp, the preferred stock pays an enormous 28% dividend. This is of course a very speculative stock play, but if one was going to speculate for the long run, it seems like the preferred stock would be the way to go.
A couple of other not so volatile examples with safer companies include Unisys (NYSE:UIS) whose preferred stock pays about 11.3%, Red Lion Hotels (NYSE:RLH) whose preferred stock pays roughly 9%, and Apache (NYSE:APA) whose preferred pays 7.27%. There are also lots of REITs and financials with preferred stock, including Morgan Stanley (NYSE:MS) whose preferred (MSZ) yields 6.5% and ING Group (NYSE:ING) whose preferred (NYSE:IGK) pays 8.2%. Indeed, among the REITs, which investors usually buy for their dividends anyway, preferred stock almost always offers higher dividends than the common stock. Winthrop Realty Trust (NYSE:FUR) pays 5.4% for example, while the preferred (FURD) pays 8.4%. New Castle (NYSE:NCT) pays 8.1% while the preferred (NCTB) pays 9.2%. There are many other examples among the more than 500 firms that have preferred stock (see my blog here for a complete listing).
Wait a minute you might say though - if bonds face interest rate risk when rates rise, don't preferred stocks face similar risk? Perhaps even more risk since they have no maturity date like bonds do? Well yes and no. Preferred stock prices are certainly going to come under pressure if interest rates rise, but because these stocks pay such high rates, the effect should be minimal. Further, since preferred stock is riskier than bonds, the effect on the safety of the investment should be greater if the economy improves. Put differently, if interest rates stayed the same, but the economy got better, preferred stock prices would go up more than bond prices because the increased safety is more significant to the stock (just as common stock prices would go up more than preferred stock prices).
For those who still aren't convinced, let's do a basic calculation. The expected fall in the price of a fixed income investment from a 1% rise in market interest rates is simply equal to the duration of the security plus the annual yield on that security. A bond (or portfolio of bonds) with 2% yield and a duration of 5 will fall 3% (-5 + 2 = -3%) when interest rates rise 1%. A bond with a duration of 20 and a yield of 5% will fall 15% (-20 + 5 = -15%) for a 1% rise in rates.
Using a duration calculator, a preferred stock with a 9% annual yield paid quarterly, and 100 year lifespan (a simplification since most calculators don't allow perpetual bonds or preferred stock), we find that the stock has duration of 11.23. So how much would a 1% rise in interest rates hurt this stock? Using our same formula from above the answer is 2.23% (-11.23 + 9 = -2.23%). Assuming interest rates don't rise for a couple of years, your dividends in the first year or two would more than offset the effects of multiple 1% rises in interest rates. In addition, it's not even clear that the preferred stock would lose 2.23% for a 1% rise in interest rates, since interest rates aren't likely to rise until the economy is on the mend and the improved economy will make the preferred stock safer which should increase the stock price. (For those sticklers out there, yes I realize you have to take into account convexity, 2.44 in this case, but its effect is small frankly especially if the interest rate increases are spread out over several years.)
The overall point here is that preferred stocks with sizeable dividends look to be good potential investments even if you believe interest rates are likely to rise in the next couple of years.
If you are concerned about the risk from investing in any single security and tying your fortunes to one company, there are also a number of ETFs that will get you broad exposure to preferred stock. These include PGX yielding 6.4%, SPFF yielding about 7%, and PFXF yielding roughly 9%.
Given these yields, and the fact that a rate hike doesn't seem imminent based on the state of the economy, these preferred stocks and others are well worth a look from many investors.