Preferred Income, A Lucrative Asset Class

Summary

Preferred stock behaves in a hybrid manner, representing both equity and bond characteristics.

Leverage has assisted in returns for this asset class.

Receiving monthly income can be attractive for those living off investments.

When it comes to investing, there are many asset classes. To name a few there is real estate, precious metals, commodities, stocks, bonds, and preferred stock. In this article, we will talk about a fund that focuses on investing in preferred stock. Preferred stock is known as a hybrid investment because even though it is equity, it behaves like a bond in a way that income is its main source of providing returns. On the other hand, since the returns preferred stocks provide are typically higher than the coupons provided by bonds, their risk is usually higher than those provided by bonds. So what is preferred stock? Preferred stock is a way of companies, mainly those in the utilities and financial sector, to raise capital. The common characteristics of preferred stocks are:

  • They are usually non-voting shares.
  • They are higher in the capital structure (more seniority) than common equity.
  • They typically pay dividends periodically.
  • The dividends they pay can be cumulative (it accumulates in case a payment is missed) or noncumulative (if the board decides to not pay dividends in a period, shareholders are not entitled to receive the dividend).

The S&P US Preferred Stock Index is a well-known index representing this asset class. The return for this index in the last 10 years has been decent. In the graph, you can see the performance, which equates to annualized rate of return of 5.21% as of 12/31/2015 since 01/01/2006.

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Source: S&P U.S. Preferred Stock Index

As for the International Index, let's ignore it for this article. You might be tempted to jump into this index via a product representing it like an ETF. Now, how about if I told you that return would have been an annualized 10.85%. Yes, that is Flaherty & Crumrine Preferred Securities Income Fund (NYSE:FFC). That closed-end fund has delivered that return for the period indicated. Now, I won't tell you it's perfect. The fund is leveraged, causing a higher volatility, and being a closed-end fund, trading at a discount or premium could also be another headache. Besides those unpleasant effects of a leveraged closed-end fund, the returns have been spectacular.

The fund is mostly invested in the financial sector.

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Source: Preferred Income

Its 25 top issuers are the following:

Source: Preferred Income

As I said previously it is risky; the fund's credit risk currently concentrates in BAA and BA issues.

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Source: Preferred Income

Also, the fund's returns are quite impressive, though volatility is present.

Source: Preferred Income

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Source: Preferred Income

Interestingly, besides this fund exhibiting volatility and being leveraged, less than 20% of its constituents are below investment grade. Also, out of those that are below investment grade, almost all are BB, the notch closest to investment grade. In the fund, the largest position represents less than 6% of the total fund, demonstrating that diversification is present.

FFC has beaten SPY since the fund's inception (without considering taxes). Clearly, the fund has had tough years, but in the long run, it has stepped up against another asset class. In the chart, Portfolio 1 represents FFC and Portfolio 2 represents SPY.

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Source: Portfolio Visualizer

Due to its low correlation with SPY, it works well to add as an asset class to a portfolio for diversification purposes.

The fund being a closed-end fund, it normally trades via different premiums/discounts. Since the fund has had a good track record, it usually trades at a premium, though those have varied in size. As of now, it is trading at a 5.68% premium making it not extremely attractive. As seen on the graph, its premium/discount history is volatile and it might be great to jump on ship once the fund goes into discount territory.

Source: CEFA

Conclusion

As some say, FFC is a monster and the returns demonstrate it. If you can stomach volatility, you will love this fund. Double-digit down years followed by double-digit up years are part of the package. If you don't feel comfortable with volatility, maybe holding a small amount in your portfolio would be manageable. As for trading the fund, premium/discount is key in addition to distribution ex-date to see when to enter and when to exit or hold.

Additional Disclaimer: This post is solely my opinion and data and information contained is not intended to be investment or tax advice. A reference to a particular investment or any observation provided in is not a recommendation to buy, sell, or hold or to make any other investment decision. If you seek advice or counseling regarding your finances or investments, please consult a professional. Investing is risky and adequate precaution should always be taken. We don't take any responsibility for your investment or other action nor we have any liability for the accuracy of the information provided. We make no representation about the suitability of the information contained herein. Past performance is not indicative of future results.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.