The Pros And Cons Of Preferreds

Includes: HYG, PFF
by: Russ Koesterich, CFA

Given the universal hunt for yield, many investors are asking me what I think of preferred stocks.

I believe that this asset class certainly has a place in yield oriented portfolios, but I wouldn’t overweight preferred equity funds at this time and would instead remain neutral. Why? While preferred funds are certainly providing a healthy, relatively high yield in a low yield environment, the extra yield comes with a lot of volatility.

Currently, preferred funds are offering a yield similar to that of a high yield bond fund, but preferred funds are also offering about 50% more volatility. For instance, the yield on the iShares S&P U.S. Preferred Stock Index Fund (NYSEARCA:PFF) is now approximately 6.5%, roughly in line with the yield of the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA:HYG). But at the same time, PFF’s three-year trailing volatility is more than 15% compared with less than 10% for HYG. (Past performance is no guarantee of future results. For standardized performance for PFF, please click here.)

To be sure, preferred stocks are generally more volatile than bonds and this makes sense given their lower place in the capital structure. However, there is another reason for the heightened volatility of preferred funds today.

The S&P U.S. Preferred Stock Index is composed of mostly financial companies. In fact, today, more than 85% of the issuers in the index are financials. This heavy concentration in the financial sector is also contributing to preferred funds’ volatility - the financial sector is now the most volatile sector in the market.

As such, preferred funds modeled on the index are essentially acting as proxies for financial stock funds, but with equity-like risk and bond-like returns. For those with a positive view on financials, this may be an acceptable risk-reward tradeoff. But as I currently hold an underweight view of global financials, I’m advocating a neutral allocation to the preferred stock asset class for now.

Disclosure: The author is long PFF and HYG.

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