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By Timothy Strauts

Savings accounts are paying less than 1%, 10-year U.S. treasury bonds are paying 2.9%, and intermediate-corporate bonds are paying only 4%, so income investors have been putting their money into preferred stocks, or preferreds. With current yields over 6%, preferred stock exchange-traded funds have had inflows of over $1.5 billion year to date.

The most popular preferred ETF, iShares S&P U.S. Preferred Stock Index (NYSEARCA:PFF), is up an impressive 11.28% annualized over the last three years. This trounces the S&P 500 return of only 3.99% and Barclays Aggregate Bond return of 6.9%. Given the recent strong performance (and performance chasing from investors), let's examine whether preferred stock still makes sense for investment today.

Preferreds 101
Before considering an investment here, it is important to understand that preferreds are a hybrid security that have characteristics of both stocks and bonds. Preferred stock is typically issued by financial institutions, utilities, and telecom firms. It makes regular income payments and is rated by the major credit-rating agencies. Preferreds have no voting rights, are senior in the capital structure to common stock, and have priority over common stock in the payment of dividends. They usually have a very long maturity of over 20 years, but they can be called at the discretion of the issuer after five years in most circumstances. Even though it is an equity security, it does not participate in the earnings growth of the company and the resulting common stock appreciation. It is priced similarly to long-term corporate bonds with a little higher credit risk. It is a unique asset class that will see many changes over the next few years.

It's All About the Financials
Financial institutions make up over 85% of preferred issuance, so the major factor affecting preferred stock prices is the perceived credit quality of the financial sector. They are many reasons to be concerned in the current environment, including the housing market, U.S. economy, and Europe's sovereign debt.

The housing market is still weak, and many forecasters are predicting more price declines. The foreclosure rate is already at an all-time high, and with 23% of properties with a mortgage underwater, it could go even higher in the months ahead. On the other hand, banks have been reserving capital to cover future loan losses for the last four years. In the last few quarters, the banks have been releasing reserves because losses have not been as bad as expected. The quality of the loan portfolio of banks is steadily improving because only 40% of the worst loans made in 2007 still exist and the underwriting since then has been very strict.

Banks are highly leveraged to the economy, so they will be one of the first sectors to feel the pain if the United States enters another recession. The U.S. economy hit a soft patch in the second quarter as most economic indicators posted disappointing results. In May, year-over-year real wages shrank. (There is no such thing as negative growth.) Since the consumer represents 70% of the economy, when their wages decline you can expect the economy to slow. The earthquake in Japan affected the global supply chain dramatically in the last quarter. With "just-in-time" manufacturing used across the globe, many factories were forced to stop production when key parts stopped being delivered from Japan. These issues are largely solved, and most factories in Japan are back to working at full capacity. Gasoline prices have declined almost 10% from their peak in May. This reduction will help low-income households the most as they spend the highest proportion of their income on gasoline.

Greece just received its second bailout from the European Union, and unless the situation improves, Ireland, Portugal, and Spain could be next. European banks are a major part of the preferred stock ETFs, and they have serious exposure to the sovereign debt of these troubled European countries. Greece's latest bailout will postpone the problem for probably another year. This will give European banks time to raise more capital and prepare for the restructuring of Greece's debt. European debt problems are real but can be managed if given time.

Regulation Means Redemption
New regulations will dramatically change the preferred stock industry. During the financial crisis, issuing new preferreds was an attractive way for an institution to increase its Tier 1 capital cheaply compared with other equity sources. The Dodd-Frank Act and Basil III rules require banks to raise their Tier 1 capital levels substantially and will eliminate the ability of preferred stock in its current form to qualify as Tier 1 capital.

It is expected that when the new rules take effect in 2013, most banks will redeem their current issues of preferred stock. The redemptions could total as high as $150 billion. This has large implications for investors in preferreds because the expectation of redemption in less then two years will help support prices in the market today. Most preferreds, except a few European issues, trade near their par value of $25; so assuming credit quality remains stable, prices should hover around $25 until 2013.

When this happens, financial institutions will need a new type of security that will qualify as Tier 1 capital. The solution supported by regulators is a contingent capital security, or CoCo bond. These new securities would be similar to existing preferred stocks except that under certain circumstances (such as Tier 1 capital falling below 7%), they will automatically convert to common stock. This obviously creates a new risk for investors, so it is expected that these new securities will have higher coupons, be more volatile, and have lower-credit ratings then traditional preferred stock. CoCo bonds are very new with limited issuance so far, and it is uncertain if these new securities will be added to the preferred stock indexes. Many preferred stock closed-end funds, or CEFs, plan on adding CoCo bonds to their portfolios, so it will be interesting to see if the preferred stock indexes and the ETFs that follow them make a similar change.

Is 6% a Fair Yield?
With most preferreds trading near par, there is minimal opportunity for capital appreciation, so yields shouldn't go any lower than 6% until 2013. Preferred stock has substantial credit risk, but when you consider that yields are still over 2% above intermediate corporate bonds, you are getting adequate compensation for the risks involved. The biggest risk investors face is the European sovereign debt problems getting worse, so you'll want to avoid Powershares Financial Preferred (NYSEARCA:PGF) with it 56% exposure to European banks.

Our pick in the category is iShares S&P U.S. Preferred Stock Index ETF (PFF) because of its lower European exposure and strong liquidity. The outlook beyond 2013 is very uncertain, so investors will need to pay attention to the makeup of the indexes as banks start offering new securities to enhance their capital positions.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.