Retirees: Look Before You Leap Into Preferred Stock

Times are tough for income-focused investors. First, the bear market did a number on most portfolios, and already-low interest rates have slunk even lower for most of the past few years. Money market yields are almost nonexistent, and intermediate-term bond fund payouts aren't much better. The Barclays Aggregate Bond Index--the benchmark for core funds like  Vanguard Total Bond Market Index (VBMFX) and  PIMCO Total Return (PTTRX)--is currently yielding about 3%. Even bond funds with a greater share of their portfolios in corporate bonds aren't paying out much more than that.

It's no wonder, then, preferred-stock funds and ETFs, some of which have yields substantially higher than what corporate bonds are yielding, have been picking up assets at a good clip.  iShares S&P U.S. Preferred Stock Index (PFF) has more than $6 billion in assets, while  PowerShares Financial Preferred  (PGF) and PowerShares Preferred (PGX) have gathered more than $3 billion combined.  

Preferreds may give income-focused investors the yield they seek without having to draw heavily on the principal in their portfolios. But those rich payouts may also provide an illusory sense of security, delivering high yields while eroding principal.

The Basics
Preferred stocks have both stock- and bondlike characteristics. Like bonds, most preferreds make fixed dividend payments. In contrast with bonds, though, many preferreds don't carry maturity dates, and those that do may mature in 30 years or more. That means that when you invest in a preferred, you won't necessarily receive a promise that you're entitled to a certain amount of money back on a certain date. And while a company that issues debt is obligated to pay interest to its bondholders, companies issuing preferred stock--like companies issuing common stock--aren't obligated to make payouts. Instead, it's up to the company's board of directors to determine whether to pay a dividend. (If a company decides to suspend its dividend to preferred stockholders, however, those dividends usually accrue until the company is able to pay dividends again.)

In terms of investor protections, preferreds also fall betwixt and between. If a company were to have difficulty servicing all of its financial obligations, bondholders would get paid first, followed by holders of preferred stock. Common-stock owners would stand last in the pecking order.

Giving With One Hand�
Because preferred stockholders don't have as many protections as do bondholders, preferred stock from a given company typically has a higher yield than a bond from the same issuer. Those rich yields are the key attraction behind preferreds, especially for income-focused investors. Another big positive is the tax treatment of preferred dividends: 15% for most preferreds, versus ordinary income tax rates for income from bonds and bond funds. And as already noted, preferred shareholders have a higher claim on a company's capital than do holders of common stock.

�But Taking Away With the Other
At the same time, the negatives associated with preferreds may override the attraction of their rich yields and generally favorable tax treatment, especially for those who want some principal stability to go with their income.

When it comes to interest-rate sensitivity, preferreds have an unattractive "heads they win, tails you lose" quality. Many preferreds are callable. That means that if interest rates go down and your preferred carries a high interest rate, the issuer can call it in by paying you back and leaving you to invest the proceeds in a lower-rate environment. And if rates head up--a more likely scenario in the coming years--you could get stuck with a low interest rate that doesn't keep up with prevailing market rates, which has the effect of lowering the value of the security. That problem is compounded, both in terms of income production and price risk, if a preferred has a fixed rate and no maturity; you'd be stuck with the lower yield in perpetuity. To illustrate the point, my colleague Josh Peters pointed to a preferred issued by  Kansas City Southern  nearly 50 years ago. With a 4% dividend rate, the preferred has been a cheap source of capital for the railroad, but a bad deal for investors looking to earn a positive real return on their money.

Moreover, preferreds are invariably issued by heavily leveraged companies, meaning they can skid in value amid a weakening economic environment. Additionally, the vast majority of preferreds are issued by financial companies, making the securities heavily beholden to the fortunes of that sector. For example, just a handful of holdings in the portfolio of Powershares Preferred reside outside the financials sector, while iShares S&P U.S. Preferred Stock also skews heavily toward the sector.

A year like 2008, when the economy spun into recession thanks to problems at financials firms, was a perfect storm for preferreds. During the market downturn from October 2007 through March 2009, for example, the iShares Preferred ETF lost 54% of its value. (Powershares Preferred wasn't around for the full period, having launched in early 2008.) That was less than the financials category average, but more than the S&P 500's 50% loss during that stretch and far worse than the high-yield bond category's average drop of 25%.

Bottom Line
So should investors avoid preferreds at all costs? Not necessarily. The recent bear market may well have been a worst-case scenario for preferreds, so it's probably a mistake to extrapolate too much of that dreadful performance into the future. It's also possible to earn a good total return on preferreds if you buy them after they've been beaten down; preferreds registered knockout gains in 2009, for example. And for investors mulling a dedicated play on the financials sector, a preferred-stock ETF helps mitigate the risks of individual common stocks and takes investors further up the capital structure at the same time.

However, it's also clear that preferreds' billing as stock/bond hybrids has been oversold: When it comes to their risk characteristics, preferreds have a lot more in common with stocks than bonds, as their showing during the bear market well illustrates. Retirees using preferreds in their portfolios should think of them as equity-light positions rather than as alternatives for the stable, fixed-income portion of their portfolios. While many retirees derive solace from building a portfolio that kicks off high current income, that's small comfort if they end up eroding their principal in the process.

A version of this article appeared Dec. 3, 2009.

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