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Should you be putting your money into stocks or bonds? How about investing in a hybrid that contains the best of common stocks and the best of corporate bonds? This financial crossbreed exists in the form of preferred stock. What some investors call an evolution, others may call a mutation by claiming that preferred stocks combine the worst of common stocks and the worst of corporate bonds.

The Best Of

  • With preferred stocks you will typically receive a consistent dividend, as you would with bonds, but they are taxed like common stock dividends.
  • Preferred stocks will give you a higher price appreciation than bonds if the common stock increases but the price will not increase at the same rate as the common stock.
  • The dividend yield on preferred stocks is usually higher than the yield on the corporate bonds.
  • Preferred stocks have the first right to dividends; Preferred shareholders will be paid before any dividends are paid out to the holders of the common stock.

The Worst Of

  • Preferred shareholders do not have any voting rights.
  • In the case of a default, bond investors have the priority in claims on assets.
  • Preferred stocks can depreciate in value, just like the common stock, although they will usually retain their value better than common stocks.
  • Rising interest rates will have a negative impact on preferred stocks.

One way to get involved with preferred stocks is through ETFs. Two preferred stock ETFs that I follow are the iShares S&P US Preferred Stock Index Fund (NYSEARCA:PFF) and the PowerShares Preferred Portfolio ETF (NYSEARCA:PGX). These two ETFs are tied directly to the financial sector as the top 10 holdings between the two ETFs include most of that sector’s major players: Barclays PLC (NYSE:BCS), JP Morgan Chase & CO (NYSE:JPM), HSBC Holdings (HBC), Wells Fargo & Company (NYSE:WFC), Morgan Stanley (NYSE:MS), and Bank of America (NYSE:BAC).

You may be wondering why you would want to have anything to do with stocks (common or preferred) in the financial sector instead of simply buying a diversified bond fund for the yield. After all, much of the decline in the financial sector since April ’10 has been due to unfavorable economic data as well as uncertainty with how the banks will cope with the financial reform regulation, the Dodd-Frank bill. Specifically within the Dodd-Frank bill is the Durbin Amendment which Bank of America CEO, Brian Moynihan, states:

The most recent, the Durbin Amendment in the interchange area, this is going to cause a significant reduction in revenue in the future and a carrying value change in our asset in the credit card business...

Caution in this area is warranted but no matter what your thoughts are about the financial sector it appears that, in many circumstances, preferred stock ETFs can outperform both common stocks and corporate bonds.

Round 1: Preferred ETFs vs. a Morningstar Analyst’s Recommended Bond Fund

I took a look at the Morningstar Analyst Research application on SeekingAlpha.com. This handy application allows you to pull up analyst research reports on over 2,000 stocks and ETFs. I pulled up the report for PFF and found that the analyst didn't seem to be a big fan of preferred stocks. The report wasn't negative, I’d say it was neutral, but the analyst recommended the Barclays Capital Long Term Bond ETF (NYSEARCA:LWC) which I put to the test.

I looked at the prices for all three ETFs around the March 2009 stock market lows through 8/27/10. LWC’s inception date was 3/10/2009 which is why that date was chosen as the starting point for this test. The results clearly favor the preferred stock ETFs:

ETF

Date

Price

% Gain

PFF

3/10/2009

$15.89

8/27/2010

$39.95

151%

PGX

3/10/2009

$6.65

8/27/2010

$14.36

116%

LWC

3/10/2009

$30.78

8/27/2010

$38.40

24.8%

The key difference between a preferred stock and a corporate bond is the possibility of a higher price appreciation in an advancing stock market. The preferred stock ETFs also boast a higher dividend yield. PFF currently yields 6.92%, PGX yields 7.23%, and LWC is yielding 5.56%.

Round 2: Preferred ETFs vs. Financial Common Stocks

Preferred stocks are not going to outperform their common counterpart when the common stock has a large upward price movement, but which one has the better performance in a market that is trending lower? I took a look at three major banks, Bank of America (BAC), JP Morgan & Chase CO (JPM), and Wells Fargo & Company (WFC), compared to the preferred stock ETFs. The financial sector hit its most recent high around the middle of April ’10 and has been on the decline since. I pulled these results from the opening price on 4/15/10 to the closing price on 8/27/10:

Stock/ETF

Date

Price

Gain/Loss

BAC

4/15/2010

$19.48

8/27/2010

$12.64

(35.1%)

JPM

4/15/2010

$47.81

8/27/2010

$36.60

(23.4%)

WFC

4/15/2010

$33.51

8/27/2010

$24.00

(28.4%)

PFF

4/15/2010

$38.89

8/27/2010

$39.95

2.7%

PGX

4/15/2010

$13.87

8/27/2010

$14.36

3.5%

The Result

The examples show that the preferred stock ETFs can outperform both common stocks and corporate bonds. The key to using preferred stocks lies in defining your thoughts about the market’s direction as well as understanding the limitations of all the financial products. The fact that preferred stocks have a low correlation to both common stocks and corporate bonds qualifies them as excellent diversification instruments.

In a modestly bullish or neutral market, preferred stocks have a good chance of outperforming bonds; Preferred stocks may also outperform their common stock counterparts due to their higher dividend yields. In an aggressive bull market, the preferred stocks will most likely underperform common stock but outperform bonds. In a bear market, preferred stocks can outperform common stocks and provide some safety due to their high yields. During this type of market, bonds may outperform preferred stocks as investors shift from the equity market into the relative safety of the bond market.

Note: The results shown in the examples represent only the price changes without accounting for any dividends.

Disclosure: Author long PFF, PGX, and BAC

Source: Profiting With Preferred ETFs