Investors in preferred shares have a couple major questions to answer. Before they can effectively determine which shares they want to buy, they need to assess how they want to use the investment. In this article I want to demonstrate how to make preferred shares a useful part of a retirement strategy. Until investors have a plan for how they want their portfolio to work, it doesn't make much sense to try to pick out individual issues.
Fitting Them In the Portfolio -- Risk Tolerance
The first rule of fitting preferred shares into the portfolio is assessing your risk tolerance. Are you comfortable with the premise of heavily limited upside and the possibility that the company could eventually default? Are you comfortable with the long duration on the shares? The effective duration (the price movement from a change in rates) is not infinite despite the lack of a maturity date. The effective duration will depend on the yield on shares. When the preferred shares are yielding in the range 7% to 10%, the investment pays for itself in 10 to 14 years.
If an investor is holding a substantial portion of their portfolio in a single sector, there is a material amount of diversifiable risk. It would be wise to limit the allocation to any sector and to design a soft cap on the allocations. For most people I would suggest limiting mREIT exposure to 5% to 10% of the portfolio. When I'm analyzing my own holdings, I don't have a problem going up to 15%, and there are some scenarios where I could go to 20%.
When I look at adding preferred shares to common equity, I want to establish a higher threshold for the combined level since there are still some diversification benefits. For instance, outside of a major impairment event, the book value of the preferred shares does not change. My most likely way to handle it will be to hold myself to a lower level on common equity so that I can look into using more preferred shares.
Bonds Are Okay
I don't mind the idea of having bonds and preferred shares in the portfolio together. I rather like the strategy. Specifically, I would want some shorter duration treasury bonds to provide more liquidity to the portfolio. When excellent opportunities appeared in the preferred shares, I would look to sell some of the short-term investments.
When investors are going into preferred shares, it is absolutely critical that they do not invest any capital they may need on short notice. It is my opinion that the best deals on preferred shares are presented in some of the least liquid markets. If an investor tries to push their way in or out, they will move the market and end up executing at unfortunate prices. Because of the poor liquidity, I favor the idea of researching several series of preferred shares and establishing the relative risk to each issue. Once we know the relative amount of risk, we can set price targets. By knowing the risks relative to each other, we can avoid doubling up on the same risk exposure. For instance, one mREIT may be vulnerable to defaults on non-agency MBS, while the other is holding very high coupon MBS that are vulnerable to prepayments.
Why Would Anyone Want Preferred Shares from an mREIT?
Since common equity has a substantially higher yield, it may beg the question why shareholders would want this. My expectation after fairly substantial analysis is that the sustainable yield for mREITs in the current scenario with a typical portfolio is running around 8% to 11% of equity. Since those mREITs trade at material discounts to book value, a larger yield can be achieved. However, events such as high prepayments can materially weaken the yield on assets and drive book values down. For many mREITs, their preferred shares have outperformed common shares over the last few years. The yield is lower, but they aren't hit with the declining book value and the enormous discount to liquidation value. Discounts to liquidation value are available, but they aren't the same as the 20% to 35% discounts to book value that are becoming common for the common shares.
When the investor is buying into preferred shares, I believe they should do so with the expectation of holding them indefinitely. If they are priced at a premium to call value, that should be factored into the analysis and is a serious threat to the investment plan. When building the portfolio, they will want to be able to build around these shares.
The logic behind assuming an indefinite timeframe is it encourages investors to factor in the full risks of what might go wrong with their investment. The potential for a default would dramatically reduce the portfolio value. To have a margin of safety, the investor should be fairly certain that no default will occur.
How to Acquire Shares
Since liquidity is a major issue here, I would favor using liquidity to the advantage of the investor. First analyze several potential securities and then set price targets for each, along with setting the maximum allocation that may be shared across similar issues of preferred shares. Once that is done, an investor can start preparing some limit orders based on their analysis of the cheapest they might expect to acquire these investments. The investor needs to be prepared to hold cash for a while and simply wait for orders to trigger.
The Forest and the Trees
When I started doing diligence on preferred shares quite a few months ago, one of the mistakes I made was putting too much emphasis on getting precisely the right estimates for yields by adjusting for when each dividend should be paid. It will be worth noting whether a dividend was paid recently or not, but I think the greater emphasis should be placed on analyzing which mREITs are strong bets to either survive or go through a very orderly liquidation that pays preferred shares a liquidation value that is above current market prices. When yields are in the 7% to 10% range, it reinforces the importance of analyzing the risk rather than grasping for another .05% of yield.
During 2016, I expect to start wading into preferred shares. My strategy will be focused on avoiding losses of principal rather than on maximizing gains.
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.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.