With Treasury yields historically low and municipal bond yields not far off that pace, income-starved investors are considering alternatives, including preferred stocks. The Principal Spectrum Preferred Securities Active ETF (CBOE: PREF) is a solid idea for investors looking to access this high-yield asset class.
Preferred stocks are a type of hybrid security that shows bond- and equity-like characteristics. The shares are issued by financial institutions, utilities, and telecom companies, among others. Within the securities hierarchy, preferreds are senior to common stocks but junior to corporate bonds. Additionally, preferred stocks issue dividends on a regular basis, but investors don’t usually enjoy capital appreciation on par with common shares.
“The securities are called ‘preferred’ because they outrank common stocks when standing in the creditors’ line, but their claims nevertheless are subordinate to those of the company’s bonds,” writes John Rekenthaler for Morningstar. “And while they technically are stocks, they have fixed par values and thus do not share in stock-market gains.”
The Perks to PREF Performance
Income investors have looked to preferred stock ETFs in their portfolios for a number of reasons. For instance, the asset class offers stable dividends, does not come with taxes on qualified dividends for those that fall into the 15% tax bracket or lower, is senior to common stocks in the event liquidation occurs, is less volatile than bonds and provides dividend payments before common shareholders.
Another benefit of PREF, particularly given the fund’s active management, is that over the past 30 years, preferreds notably outperformed broad-based fixed income indexes.
“Conversely, when preferred stocks collapsed, during the 2008 global financial crisis–an unsurprising outcome given that banks are by far the largest issuers of preferred stocks–utilities performed relatively well. This behavior suggests that preferred stocks and utilities be held together,” notes Reckenthaler.
As a high-yield asset class, preferreds historically perform well as interest rates decline. Rates are certainly faltering this year, but that also means yields on preferreds are declining. However, some market observers don’t see that as a mark against the asset class. PREF can also be paired with other non-bond income assets.
“Another idea is to use preferred stocks and utilities to create an alternative version of a balanced fund. Instead of pairing conventional stocks with bonds, use a blend of preferred stocks and utilities stocks. Doing so will decrease portfolio diversification, because unlike bonds those hybrid investments are correlated with equities, but perhaps their extra returns will offset their additional risks,” according to Reckenthaler.
For more on multi-factor strategies, visit our Multi-Factor Channel.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.