As most of you know, I am a big fan of preferreds. In fact just by looking at my portfolio, most of you would consider my portfolio overweight in preferreds. For me, yield is more important than appreciation because I am guaranteed an income stream.
However, there are instances where buying preferreds doesn't make much sense to an income investor. Remember that as income investors we pretty much just care about a nice quality yield, where the underlying company makes sufficient cash flow to make those payments. This is why we are willing to sacrifice principal appreciation and instead opt for a high yield. So there is a clear tradeoff between common and preferred stock.
As the preferred market has snapped back into reality, I have been scavenging to see if I can pick up some great yield. Many preferreds are now under par after investors were spooked by rumors of rising rates. Due to a bond-like quality, preferreds are inverse to interest rates. So rumors of rates rising did cause principal to fall in order to increase yields.
Since preferred investors are sacrificing appreciation, then they need to be rewarded appropriately with a high dividend. However, there are a few preferreds I believe are not as good of an investment as their common stocks.
I got the idea for this article after I saw a new preferred IPO. Costamare (CMRE), a Greek shipping company, issued its series B preferreds late last month. The preferreds have a yield of 7.63% on par value. The preferred is trading slightly below par so I decided I would look into it and maybe grab a bite. However, after looking into the common, I realized that the preferred doesn't provide an adequate return. This is because Costamare's common has a yield of 6.10%.
The dividend yield spread between the preferred and the common is around 1.5%. This isn't a large spread given the fact that with the common, you are entitled to an equity stake. The other concern is that the common has actually raised its dividend in 2011 from 25 cents to 27 cents.
So why would I buy the preferred, when I can get the common and potentially see price appreciation and dividend growth?
Stag Industrial (STAG) is also another one where the preferred doesn't offer an appropriate return. The yield on cost for the series B preferred is 7.35%. The common currently had a yield of 5.8%. There is about a 1.55% spread between the two. This is not enough of a cushion given that just like Costamare, you can potentially receive equity upside and dividend growth. Stag has grown its dividend from 20 cents in 2011 to 30 cents in 2013. So the dividend growth alone could take the yield closer to the preferred.
The preferreds in these two cases are poor investments because the yield is not sufficient enough to justify an investor to sacrifice principal. It is very important for investors to be aware of the underlying stock when dealing with preferreds. Sometimes the risk-reward may not be that great. I don't think a spread of 150-200 basis points is worth it when you have to give up so much. It's also likely that spread could decrease if the common dividend increases.
Investors can use this strategy to best determine if the preferreds are an appropriate investment for them. It might even be a good way of identifying potential short opportunities in the preferred world. These preferreds may likely fall farther so a greater spread can exist. While I personally am against shorting preferreds due to low liquidity and high dividends, others may be willing to take the risk. Investors should best determine how much of a spread is necessary for them to invest in the preferreds.