7+% Yields From Preferred Shares; The Good, Bad, And Ugly

Includes: BAC, C, JPM, PFF, PGF, PGX
by: AlanHHI

Those of us who have invested in high dividend paying stocks this year have been well rewarded, especially if we've invested in the very high yielders like preferred stocks from financial institutions.

Preferred stocks are generally more like bonds than common stocks. They are designed to pay a dividend that never increases. The dividend amount is set so that the stock will yield a certain interest rate, and the market then prices the stock so that the yield actually paid will be what the market believes the yield should be at a certain time and date. For example, one of the stocks that I own is Bank of America Series H (BAC-H). It was originally issued to yield 8.20% interest. Since preferred stocks are almost always issued at $25 per share the dividend paid by BAC-H is $0.5125 each quarter ($2.05 each year; 2.05/25 = 8.20%). At the current price of 25.80, the yield is 7.95%.

Preferred stocks - The good, The bad, and The ugly

The Good

  • Preferred stocks are much safer than the common stocks issued by the same company because even normally a company can't pay a dividend on its common stock if it is not paying dividends on any of its preferred stocks.
  • In some cases the preferred stock is "cumulative" and the company must make up all dividends not paid on its preferred stocks before resuming dividends on its common stock. In other cases, the preferred stock is not cumulative, and the company can resume common dividends as soon as it starts paying dividends on its preferred stock (BAC-H is not cumulative).
  • Thus, preferred stock is often viewed as a junior bond, and rated as such. The current S&P rating for BAC-H is BB+.
  • Preferred stock yields are very attractive. The yield on BAC-H is about 8% and several other preferred stocks are available with yields of about 7% or more (e.g., ING Group Preferred (IDG), Citigroup Capital XX (C-G)).
  • Preferred stocks have enjoyed great capital appreciation over the last 12 months. BAC-H was priced at less than $20 last November when Europe was scaring most of us half to death. Now that things in Europe look better (not good, but better), BAC-H is priced at 25.80. If you bought BAC-H in the crisis and still hold, it you would be looking at a gain 29% in addition to the great dividend! This experience has been similar for other preferred stocks.
  • As described below, investing in preferred shares requires special expertise. Fortunately, several ETFs have been developed to supply this expertise:
    • iShares S&P US Preferred Stock Ind. FD (NYSEARCA:PFF)
    • PowerShares Fin. Preferred Port. (NYSEARCA:PGF)
    • PowerShares Preferred (NYSEARCA:PGX)
  • Even though the yields for these ETFs are 50 basis points or more less than you could get by picking the preferred shares themselves, the yield is still substantial (6% - 6.5%).

The Bad

  • As noted above, investing in preferred stocks requires significant specialized expertise. When I look over preferred shares I have to take into account:
    • Call dates. If the stock is over $25 and it is called there can be a capital loss.
    • The location and credit standing of the company. Personally, I have investments in the preferred shares of the strongest countries in Europe (e.g., ING Group (Netherlands)). I also have investments in preferred shares of banks that have passed the Fed's most recent stress tests (Bank of America (NYSE:BAC), Citigroup (NYSE:C), and JP Morgan Chase (NYSE:JPM)). Many others would consider these investments too risky.
    • Liquidity. Many preferred shares trade so infrequently that selling them can present a real problem
  • Most preferred stocks have corrected completely from last November. Further price appreciation is not likely.
  • There is no standard for preferred share stock symbols, which can become a major annoyance. I have seen the symbol for BAC-H shown as:
    • BAC+H
    • BACpH
    • BAC/PRH
    • BAC/PrH

The Ugly

  • When times get rough, hedge funds often attack the financial stocks and these attacks can spread to the preferred shares as well. When the Europe was in crisis in November of 2011, shorting of European bank stocks was prohibited. Methods were developed to short the European banks that also affected American banks. This American bank "collateral damage" spread to American bank preferred shares as well.
  • Eventually, general interest rates will increase, and then the value of preferred shares will drop sharply.
  • At today's very low interest levels it may take a while for the prices of the preferred shares to drop significantly. For example, when the yield on the 10-year US Treasury went from 1.4% to 1.8% the price of BAC-H barely moved. I would not imagine much change in price in the price of BAC-H until the 10-year rate returns to something close to normal (perhaps somewhere between 3% and 4%). When treasury rates get to this level, whatever it is, then the preferred stock party is over and I hope I have left before that day occurs!
  • The ETFs mentioned above do not protect you from either collateral damage or a rise in interest rates. The ETFs will be hit just as hard as the preferred shares themselves.

The bottom line is that preferred shares or their ETFs can supply a very nice yield in this unusually low interest environment. That yield is still available, and is likely to stay here for a while. However, there are a couple of "uglies" that investors need to be aware of, and you should decide whether you have the stomach for these before you join this party.

Disclosure: I 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.