Preferred Stock Isn't The Way To Go
- Preferred Stock Comprises a Small Fraction of the Market Capitalization of Stock and Bond Markets.
- Issuance of Preferred Shares is Highly Skewed towards Financial Companies.
- The Behavior of Preferred Stock can be Substantially Replicated with Conventional Stock and Bond Holdings.
The persistent repression of interest rates has led investors to consider a number of riskier fixed income options in recent years. High yield bonds, Real Estate Investment Trusts (REITs) and bank loans count among the alternatives considered. One area that's received less attention is preferred stock, an investment with a high distribution yield of 5.3%. It's worth taking a closer look.
Preferred stock occupies an intermediate position in the firm's capital structure. Its shareholders' claim on corporate assets are junior to bondholders while remaining ahead of common stockholders. Consequently, preferred stock issues are not part of the better known investment benchmarks such as the S&P 500 and the Aggregate Bond Index.
Preferred stocks typically have credit ratings and these are lower than the bonds issued by the same company. Most of the ratings are at the low end of investment grade or junk credits. The liquidity of the preferred market is also similar to that of junk bonds.
Shouldn't a diversified portfolio have some preferred stock? After all, market cap weighting demands that all public securities be included or, at least, essentially represented. The answer is yes ... and no. Preferred stock is a miniscule market when contrasted with America's large stock and bond composites.
As of June 30, 2015, the market cap of publicly traded preferred shares in the U.S. was about $241 billion. Sounds like a lot but it's barely 1% of the 22.71 trillion equity market. It's a similar story with bonds. Preferred stock represents about 3% the size of the US corporate bond market. It's rounding error when weighed against all US bonds. You'll note that its market size is hardly visible in the pie chart below.
So ... the size of the preferred stock market does not make a compelling argument for its inclusion in a well diversified portfolio. What about its performance characteristics? Do they merit special attention.
Any enthusiasm for the preferred stock must be tempered by the fact that it is a heavily concentrated composite of securities. Almost 85% of the preferred shares today were issued by financial companies. That's even more troublesome than it sounds. Not only is the preferred stock finance heavy, but its industry concentration has flipped in the last 25 years. Until recently, the space was dominated by utility issuers! From 1950 to 1979, 90 of the 108 preferred stock offerings were issued by public utilities.
That instability in the preferred stock index's composition makes it difficult to evaluate its performance characteristics over an extended period. It's a moving target. That limits our ability to infer diversification properties from time series analysis.
That said, there are some investable securities that represent a broad swath of the modern preferred stock market. The Ishares Preferred Stock Index ETF (NASDAQ:PFF) is the largest and most liquid product available for the retail investor to trade. Its performance characteristics since inception in 2007 are described along with other relevant benchmarks below. Recall that the credit quality of preferred shares is low so a high yield bond composite is included as a basis of fixed income comparison.
The recent data is hardly a ringing endorsement of preferred share performance. Volatility was sky high over the period - in part due to its high concentration in financial issuers. Note that financial stocks themselves were poor performers over the same time frame. The S&P preferred stock index mimicked by PFF fell well over 50% during the great recession. That's more than the US stock market!
As an additional exercise, I performed a regression to determine if the preferred share performance could be reliably expressed as a linear combination of a high yield bonds and financial stocks. Without getting into the weeds, the answer is ... partially. These two indices explain about 45% of the variability in preferred share returns. That's pretty substantial explanatory power for two variables selected with an educated guess.
However, 55% of the variability of preferred stock is NOT explained by the regression. That leaves open the possibility that preferred shares might bring something to the table from a diversification standpoint. Historically, their returns have been driven by regulatory changes that do not affect core asset classes.
In the mid 1990s, banks started issuing preferred shares because they qualified as tier 1 capital to meet regulatory obligations. More recently, the Dodd-Frank act phases out this tier 1 status. Changes in the tax code have also created demand shocks for preferred securities. One could argue that preferred stock is a contrived part of the capital structure that responds uniquely to government policy.
Yes, preferred stock has outperformed inflation over the last nine years and may have unique performance characteristics. But that favorable observation is swamped, in my view, by a number of negative attributes.
- Preferred stock is an insignificant part of American capital markets
- It is now concentrated in financial firms after recently being dominated by utility issuers. As such, it may be more of a regulatory refuge than an asset class
- Its recent returns and volatility are inferior to both junk bonds and stocks.
- During the Great Recession, preferred stocks suffered MORE than common stocks.
I doubt that preferred stock will enhance return or reduce volatility in an investment portfolio. However, a small allocation to preferreds is, at worst, a minor mistake. From a distance, it will look like a mild tilt toward junk bonds and financial stocks.
This article was written by
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