A peek inside this newly created Morningstar Category.
On Nov. 4, Morningstar launched new categories for open-end and closed-end mutual funds and exchange-traded funds. The preferred stock category includes funds with a majority of assets invested in preferred stock over a three-year period. Previously, most preferred share funds were lumped in with long-term bond funds because of their historically high sensitivity to long-term yields. Preferred shares have exhibited much more equitylike behavior in recent years, though, especially in periods of market distress. In fact, the historical correlation between the new preferred stock category and the now preferred-share-absent long-term bond category has come down (just 0.63 over the trailing three years ended October 2013 and 0.57 over the trailing five years). Although those correlations over the past year have increased (0.80), the new category provides better comparison groups for both preferred share funds and those remaining in the long-term bond category.
Note that Morningstar prefers to see a minimum number of funds before creating a new category but doing so now made sense given the aforementioned changes. In 2012 and 2013, seven new preferred share CEFs launched bringing the total number to 17 today. Before delving into the current category, a review of this less familiar asset class is in order.
Preferred Shares 101
Preferred shares are hybrid securities with characteristics of both equities and bonds. Financial institutions, utility companies, and telecommunication firms issue the bulk of these securities. The attractiveness of preferred shares stems from regular income payments that are typically higher than interest earned on a bond issued by the same company, they are senior in the capital structure to common stock, and have priority over common stock in the payment of dividends. They do carry added risks beyond those of bonds, though. First, preferred shareholders have no voting rights and are junior in the capital structure to a company's bonds. Second, these securities typically have long maturities (often more than 20 years), but many can be called (usually at par value) at the discretion of the issuer (typically after a five-year lock-up period). And, although they are equity securities, they don't participate in the earnings growth of a company or its resulting common stock appreciation.
A number of regulatory issues festered in the market following the 2008 crash, though many lingering questions have been resolved. In short, banks were big issuers of a certain type of preferred share (trust preferred shares) which, after a phase-in period, will no longer count as equity in capital ratios, which regulators use to measure a firm's levels of debt and equity. In the time between the announcement of proposed changes in 2010 and the adoption of the rules this summer, many banks redeemed outstanding trust preferred shares in favor of equities, and sometimes issued traditional preferred shares, which still count toward a firm's equity stake. The redemptions caught some investors by surprise especially after many preferred securities were trading above par due to high dividend rates. Those early redemptions and limited new issuance steadily decreased net supply.
The shrinking of the preferred-share market, coupled with yield-hungry investors wooed by high payouts of preferred securities, pushed underlying CEF net asset values higher in an asset class that generally does not experience a great deal of capital appreciation. Though the smaller new-issue market included many less-appealing options, due to the sustained low-rate environment, CEFs have a distinct advantage of a closed capital base. Mutual funds and exchange-traded funds are forced to purchase securities when money flows into the funds (and to sell when assets flow out), but CEF managers can be more methodical about buying and selling securities. The preferred-share mutual funds and ETFs gathered $5.4 billion in assets during the past three years but have lost $1.5 billion over the trailing 12 months.
Preferred Stock CEFs
Table 1 below lists the 17 CEFs comprising the new preferred stock category. Discount and valuation data, leverage ratios, distribution rates, and the Morningstar Analyst Rating are included.
Although these funds have benefited from an advantageous supply/demand story, the Federal Reserve's taper talk in May took a bite out of returns, causing share prices to plummet in the second and third quarters of 2013. Preferred shares have long durations (some are perpetual), which have historically made them sensitive to changes in interest rates. However, their equitylike characteristics insulated the group somewhat during the second and third quarters of 2013 when the average preferred share CEF lost 1.9% of underlying net asset value compared with a 2.5% loss for the average long-term bond CEF.
In addition to the volatility of underlying NAVs from changes in interest rates, preferred share CEFs are also susceptible to volatility in share prices as investor sentiment shifts. These funds are not for the faint of heart, nor are they meant to serve as stand-ins for a generic bond allocation in a portfolio. Investors can expect these funds to experience increased volatility as the market whipsaws following announcements of economic data and any communication from members of the Federal Reserve. While preferred share CEFs can provide a boost to a portfolio's overall yield, these funds should be small holdings, at best, in a well-diversified portfolio.
Click here for data and commentary on individual closed-end funds.