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Summary

  • Preferreds have attracted many income investors since the recession.
  • Yields are high, which can be enticing, but these investments are not for everyone.
  • Preferred investors must be prepared to hold for a very long time if rates rise.

I have recently been getting a lot of emails and messages from investors curious about the future of preferreds. In my last article, I wrote about Northern Trust's (NASDAQ:NTRS) new preferred, and described it as a good stable distribution for income investors. However, I should really clarify that investing in preferreds is not for everyone. Sure, it is great for income investors to see a nice yield over 6% in a low-rate environment, but there is one major risk that many need to think about before buying these securities.

So what do all preferred investors need to keep in mind?

Be prepared to hold forever. Remember this sentence every single time you contemplate buying preferreds. Repeat it multiple times if you have to.

Preferreds are essentially fixed income securities, but most do not have a maturity, unlike bonds. So when rates rise, these securities will fall in value. The only reason an issuer would consider calling a preferred is if they can issue a newer one with a cheaper coupon rate. This is unlikely to happen, as rates can't go lower.

When rates rise, preferred values fall, this means that the only way the investor can get out is by selling for a loss. It's pretty simple. So if you buy a preferred now and like the yield on cost, you have to be willing to accept this yield going forward, whether it's 5 years or a 100 years.

Now there is no telling where rates will be 5, 10, 15 years down the line. Everyone tries to predict the future, but as an income investor, you have to be aware of your comfort level when buying preferreds. I wish I could sugarcoat these securities, but that would be unfair to you.

Now for those that are comfortable with essentially holding "forever", don't be turned off. These securities can provide consistent distributions. Assuming the issuer is strong, you have even less to worry about.

Take, for example, JPMorgan's (NYSE:JPM) series W preferreds, which currently have a yield on cost of 6.35%. While many are aware that banks can be volatile, this preferred is still tied to the largest bank in the country. The S&P credit rating for JPM is BBB. If investors were to buy JPM series W preferreds, they will be locking in this yield and must get comfortable knowing the price is likely to decline.

If you are someone that has an infinite hold period, but are willing to take a consistent stream of distributions, then preferreds are for you. If you are someone that is focused on the value of these securities going into the future, then these might not be for you, as they are likely to decline going forward.

Source: Preferred Stocks Are Not For Everyone