By Carla Fried
In a recent round up of 2014 income opportunities, Barron's made a pitch for preferred stocks as a solid choice for income seekers, given eye catching yields of 7% or so these days, and better liquidity than corporate bonds.
And as the article pointed out, some preferreds dole out "qualified" dividends that are taxed at a max federal rate of 20% (or 23.8% if adjusted gross income is above $250,000 for a married couple.) That's a nice advantage over traditional bond income that is taxed at your ordinary income tax rate, which can now reach above 40% once you factor in new ACA-related surtaxes on high income earners.
There's no question 7% is alluring. The yield of the $8.4 billion iShares U.S. Preferred ETF (NYSEARCA:PFF) outpaces both the biggest junk bond fund, the SPDR Barclays High Yield Bond (NYSEARCA:JNK), and the leading bank loan ETF, the PowerShares Senior Loan Portfolio (NYSEARCA:BKLN):
But what wasn't explicitly spelled out was the risk you have to take to pocket preferreds' higher income payouts. Preferred stocks are typically issued for a very long term -- 30 years is common -- and dividend payouts are fixed. Sound like a bond? Yep. And thus, rising interest rates are kryptonite for preferreds. Here's how the iShares U.S. Preferred fared last year when the 10-year Treasury had its big spike:
PFF Total Return Price data by YCharts
PFF's 6% loss during that stretch (that included the reinvestment of dividend income; the principal price decline was 7%) essentially wiped out all the income paid out for the entire year. For the calendar year the ETF's total return was -1%. If you're in the camp that believes last year's rate rise was the big move for now, then you don't have to worry about what another big jump might do to preferreds. But if you appreciate that the 10-year Treasury still has a ways to go before it gets back to "normal," that suggests more pressure on preferreds when rates do rise.
If that 7% remains too good to ignore, and you're leaning toward the iShares U.S. Preferred ETF, you'll want to tuck the money into a tax deferred account. While some preferreds pay qualified dividends that are taxed at 0 to 20% (23.8% when adjusted gross income exceeds $250,000 for a married couple), the iShares portfolio owns plenty of issues with unqualified dividends that are taxed as ordinary income. For the 2012 tax year (the latest data available) just 53% of fund income qualified for the lower dividend tax rates.
And one final caveat: Preferreds are pretty much a one-sector game: financials. Something to consider in an environment of rising rates is whether the lower-yielding common stock is the better investment; at least from a total return perspective. For example, Wells Fargo's (NYSE:WFC) preferred stock currently yields about 7%. But given last year's rate rise its total return (price change + yield) was 2.1%. Wells Fargo common has a dividend yield of just 2.5%, but total return last year was above 35%. And with the common you have the prospect of a rising dividend payout (or cut during recessions.) That's not something fixed-rate preferreds offer.
Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine.