Why I Strongly Disagree With 'Why You Should Avoid Preferred Stocks'

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Includes: BEE, CDOR, FCH, PFF
by: Norman Roberts

Summary

A MoneyWatch article titled, "Why You Should Avoid Preferred Stocks," interested me and I took a look.

Some points I agreed with, most others not at all.

Are preferred call provisions really a negative as the author claims? I think not.

You now have two diametrically opposed points of view to reflect upon.

Because I am a knowledgeable and successful preferred equity investor, a large majority of my SA articles have been dedicated to explaining the benefits of investing in such securities. As a result, I have discovered, from a number and variety of comment section responses, that there appears to be a general lack of information and misconception concerning these securities. As evidence of this, one commenter provided a link to a 2012 MoneyWatch article titled, "Why You Should Avoid Preferred Stocks." Obviously I was interested, and I admit, mildly perturbed by what I read. Consequently, I have decided to utilize this article in this response, and to help me, I have block-quoted several paragraphs, which I intend to refute and discuss to help make my case.

(MoneyWatch) The low interest rates on government and high-quality corporate debt has meant that many investors can no longer generate the kind of income they need (or were used to). Faced with this dilemma, many seek higher yielding forms of fixed income. This search often leads to preferred stock, with the 30-day yield on the iShares S&P Preferred Stock Index Fund (PFF) about 6.45 percent as of March 30. But what (if any) role should they play in your portfolio?

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Immediately, I noticed the author use the Preferred Stock Index Fund (NYSEARCA:PFF) as his preferred equity example, which is misleading in so many ways, including:

  • The preferred equities I invest in are certainly not funds. They are primarily fixed income, cumulative, offer a relatively high yield return, and are issued by single companies.
  • PFF is certainly not fixed income because its dividend varies monthly and on a yearly basis as shown in this five-year dividend summary at DividendInvestor.com. One of my favorite and often visited web sites that I suggest you bookmark.
  • PFF is also a fund that charges approximately 1/2% for their service. An expense any knowledgeable can avoid by doing his own research and due diligence and creating his own portfolio of preferred equities.
  • On April 2, 2012 PFF traded at $38.79; it closed Fri. at $38.48. However, during that time the investor would have earned $9.5639 in dividends: 9.5639/38.79 = 24.7/4 years = 6.16% yield per year, less a slight loss of .31. Nothing spectacular, but not bad either.

The author states that preferred shares stand behind debt in the event of bankruptcy, which is correct, and something, I suspect, is no secret from any of us. He states that preferreds have no maturity date and can be perpetual, which is quite okay with me, for as far as I'm concerned, my preferreds can keep throwing off those fixed dividends forever. I like 'em.

He claims that long-term maturity increases the risk, which might be the case in some instances; however, preferreds are not chained to your wrist; you can sell them at any point, at a profit, loss, or at break even. Then in the next paragraph the author decries the call provision, lamenting the government securities have none, meaning you can hold them:

Call provisions

U.S. government debt has no call provision (giving the issuer the right, but not the obligation, to prepay the debt). Thus, government debt (as well as all non-callable debt instruments) has symmetric price risk. A 1 percent rise or fall in interest rates will result in approximately the same change in the price of the bond (in the opposite direction). This isn't the case with callable preferred stock:

  • If rates rise, the price of the preferred stock will likely fall
  • If rates fall, the issuer will likely call the preferred stock and replace it with a new preferred issue at a lower rate, conventional debt, or perhaps even common stock

Thus, you have asymmetric risk -- you get the risk of a long-duration product when rates rise, but the call feature puts a lid on returns if rates fall. Thus, preferred stocks rarely trade much above their issue price. It's important to note that almost all callable preferred stocks are callable at par. Thus, there's extremely limited upside (virtually none if the call date is near) potential if the security is purchased at par.

Having protection from calls is important to income-oriented investors for another reason -- callable instruments present reinvestment risk, or the risk of having to reinvest the proceeds of a called investment at lower rates. Through calls, investors lose access to relatively higher income streams. Thus, part of the incremental yield of preferred stocks relative to a non-callable debt issuance of the same company is compensation for giving the issuer the right to call in the debt should the rate environment prove favorable.

The above block-quote is incorrect, for the following reasons:

  • Government debt is safe, yes, but the yield is pitiful, and should you decide to sell at an inopportune moment, you could suffer a loss of principal.
  • Yes, preferred stocks rarely trade above issue price, but appreciation is not the reason a preferred investor buys a preferred. He buys it for the fixed income, and if he's a smart shopper (never buy retail), he buys during opportune moments when share price is depressed for a number of reasons, as I have outlined in multiple articles, giving him enhanced yields plus the upside profit should the dreaded call, the author laments, occur.
  • Reinvestment risk? There is never risk of a wave of calls as a result interest rate fluctuation. It's usually when an individual company finds it advantageous to call a specific preferred, and at a time they can actually afford to pay for those called shares. When this happens it is usually a solitary event, which any preferred investor can replace readily with any number of opportunities offered by other companies that might even offer richer yields than he has been forced to relinquish. Or he can wait until the next market contraction or other event that depresses prices, whereby he can really make a great buy with the money earned by the called shares.

The author mentions the relatively poor credit quality of preferreds, specifically concerning PFF's holdings, which, I have to confess, are much better than those held in my portfolio. Many of the preferreds I hold are unrated, which is okay with me. Unless when I'm really taking known risk, like I did with the wildcatters, and recently shipping, I consider most of my portfolio relatively risk-free. I say this because I know the only way I can truly lose is in the event my companies go bankrupt. However, even during the worst of times, if one can afford to hold, even during extreme events, when the cumulative preferred dividend is suspended, should the company survive, and the moment preferred investors get wind of this, those preferred share prices will skyrocket to well over their issue price, specifically because those suspended dividends will have to be repaid the then holder. A recent prime example of this occurred with Supertel Hospitality Trust (SPPR), which became Condor Hospitality (NASDAQ:CDOR), which I lamented in a recent article, I found another way to lose... Last week, I believe it traded above $31.00. I'm still suffering from the pain of being too smart by a 1/2.

Then there are Felcor Lodging Trust (NYSE:FCH) and Strategic Hotels & Resorts (NYSE:BEE), where I made a killing by buying them in 2009, at single-digit prices, when they were facing bankruptcy, had suspended their preferred dividends, yet survived and were later called. This is not an uncommon occurrence. Below are screen shots taken from a 2010 spreadsheet I created to record the transactions that went to comprise my existing portfolio. The first column to the right of share symbols listed the yearly dividend totals, followed by the cost of purchase, the yield %, number of shares purchased, price per share paid, date of purchase, dividend per share. At the time of purchase, all the dividend payments had been suspended. All have now been called, and all the missed dividend payments have been repaid. A tremendous win.

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The author spoke of why companies issue preferred shares, which I couldn't care less about. He spoke of how a company's credit rate risk and interest rate risk could depress the price of the preferreds, which I agree with, and similarly don't much care about. Since I'm not selling and they keep paying those lovely dividends, I'm happy. And I know that when they want me out of their pocket, they have to buy me out at the issue price. Furthermore, if you have not leveraged yourself to the point of a margin call, or don't suddenly require access to lots of money, unrealized losses or gains mean little. During the real estate crash of 2008-9, my home's value plunged, which had absolutely no ill affect as far as I was concerned. I was not selling or considering borrowing against it. In fact, the effect was positive; my property taxes were reduced.

The author states why corporations might benefit by buying preferreds because of favorable tax treatment. Then he claims that individual investors "get no such favorable treatment." Many of my preferred payments are either qualified at 15% or 20% depending on my tax bracket, and others are determined as ROC, return of capital, which means tax free. That's no tax at all. Yes, it reduces your cost basis, but a long-term capital gain is capped at 15%, and in the event you sustain losses, as I did liberally last year, uggh, I paid no capital gains tax at all.

There are some other reasons to consider avoiding preferred stocks. First, because of the need to diversify the risks, one shouldn't buy individual preferred stocks. That means you need to buy a fund such as the aforementioned PFF and incur expenses of 0.48 percent. Since investors in Treasuries, government agencies or FDIC-insured CDs don't need to diversify, they can eliminate the expense of a fund altogether. Or, for convenience purposes they can use funds with much lower expense ratios (such as those offered by Vanguard). Thus, some of the higher yield the market requires for preferred stocks will be spent on implementing the strategy. The result is that investors don't earn the full risk premium the market requires. Second, if you buy individual issues, you have the trading costs, the lack of diversification and the need to constantly monitor credit ratings. Also, the typical lengthy maturity of preferred issues increases credit risk. Many companies might present modest credit risk in the near term, but their credit risk increases over time and tends to show up at the wrong time.

This paragraph is incorrect in many ways, including:

  • PFF charges, according to the author, a .48% management fee, which a savvy investor doesn't pay by buying preferred shares directly through his brokerage account.
  • I pay $5.00 per 1000 shares purchased, virtually nothing.
  • My portfolio is diversified because I chose it to be.
  • Government bonds offer a pathetic yield for the supposed safety they offer. Safe yes, unless you are forced to sell them at an inopportune moment when you need the cash and their price might be depressed.
  • We already discussed the issues about the lengthy maturities.

The remainder of the article really added nothing new and worthy of my time to review. But don't take my word for it. You might want to read his article in its entirety, then take the time to consider its claims, and my response, then form your own opinion, which is the only one that really matters.

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: I believe this is a frank debate about preferred investing, which will be of great benefit for SA members considering their purchase.