Preferred stocks offer investors an alternative to bonds

Amid a retreat from stocks, bonds this year have become more popular than at any time since 2008, as investors fearful of impacts from Brexit, trade tensions and a potential recession have settled for lower yields to reduce risk.

In the 12-month period preceding September, investors poured more than $293 billion into bond funds in a trend that has continued through the fall. But in their flight from stocks, many investors are overlooking a practical alternative to bonds that typically pays higher yields: preferred stocks.

Far different from common stocks (the equity form normally referred to simply as "stocks"), preferred shares are something of a hybrid between stocks and bonds. Preferred stocks are technically a form of equity, like common stocks. They're traded on exchanges, but they're structured differently to meet different financial goals for companies that issue them.

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For investors, they behave more like bonds, with returns that are almost bond-like in their reliability. Though more volatile than bonds, this relatively small universe of assets (owned primarily by institutional investors) poses less risk than common stocks.

The historically low yields currently paid by various types of bonds make preferred stocks worth a close look, as their dividends tend to be far higher than the yields of all types of publicly traded bonds, and 2019 has been a particularly good year for preferred shares.

Preferred stocks are issued primarily by banks and financial institutions, but also by utilities, real estate investment trusts and other types of companies. The concentration of preferred stocks in the financial sector might normally be viewed as posing industry risk, but regulations that stemmed from the financial crisis of 2008 have made these institutions safer from default risk than they've been in decades.

As with bonds, investors can manage risk by choosing companies with high credit ratings. And investing in preferred stocks is more about reliability of income than the growth potential of a given company or industry.

Here are some advantages of preferred stocks:

• Preferred shares have historically delivered yields higher than those of bonds, but because interest rates have dropped dramatically in recent months, they're now far superior. According to Morningstar, as of Nov. 19, the largest preferred stock index exchange-traded fund was yielding 5.3%, about twice the yields of the ETF tracking the Bloomberg Barclays Aggregate Bond index (2.7%) and the largest municipal bond ETF (2.4%).
• Better tax treatment. After taxes, preferred shares do even better compared with taxable bonds, as many of their dividends are qualified, the long-term rate for which is 15% for most people and about 20% for the upper bracket. Bonds yields are generally taxed at the higher ordinary-income rate. Preferred stock income's status as qualified income means that their after-tax yield is currently higher than that of municipal bonds.
• Lower risk than common stocks. Though preferred shares are a form of equity, they have a low correlation with common stock: Their value doesn't tend to rise or fall with that of common shares. Typically, when common shares rise significantly, preferred shares don't rise nearly as much. But when common shares fall precipitously, preferred shares tend to retain more of their value. So, while preferred stocks don't have common stocks' potential for value appreciation, they generally offer stability.
• In the event of default, preferred shareholders are paid before holders of common shares, but after bond holders. Accordingly, companies' credit ratings for preferred shares tend to run slightly lower than their bond ratings.
• Some insulation from interest-rate risk. Bonds are subject to risk from rising interest rates, as they're worth less on the secondary market when companies issue new bonds that pay higher rates. The value of preferred shares is affected less by interest rate fluctuations than by changes in the issuing company's credit.

A key downside for individual investors is that preferred stocks are considerably more complicated internally than bonds and common stocks. There are several different varieties, each with different rules of the road. Some can be converted into common stock and some can't; some have a set maturity (as with bonds) and some don't; rates may be floating or fixed; and some pay missed dividends retroactively while others don't.

One type of preferred shares that can easily trip up individual investors is callable preferred stock. When issuing these shares, companies reserve the right to buy them back from the purchaser at a set price whenever they choose, in keeping with set rules. This can happen when the market becomes advantageous for selling lower-yielding bonds.

Owners of callable preferred shares may not have time before calls to get enough income from the shares to justify the purchase price, relative to the pre-set call price. This concept, which also applies to bonds, is known as negative yield-to-call.

Information on what preferred share issues have terms likely to result in negative yield-to-call values is difficult for individual investors to come by, and analysis of the likelihood this prospect can involve extensive calculations that can be vexing for individuals. This and other complexities mean that most individual investors are better off investing in preferred shares through funds.

In keeping with the long-running trend toward passive management, most individual investors seeking preferred stocks use index funds. But the index that passively managed funds track includes callable shares. This variety, which can easily have negative yield-to-call characteristics, typically comprises about one-third of the market, so it's virtually impossible to avoid these when buying index funds or passively managed ETFs. The only way to avoid callable shares in funds is to confine investment to actively managed funds.

Over the past decade, actively managed preferred stock funds have beaten index funds handily. Data from Morningstar show that since 2009, the average returns of actively managed mutual funds have been about 1.5 times those of passively managed funds, and that active management beat passive in eight of the 10 years. Despite that outperformance, about 85% of the more than $31 billion of assets in preferred stock ETFs is managed with index-based strategies.

For common stock refugees seeking greater security with more income than bonds can provide, a judicious allocation to preferred stocks may be appropriate. Not only can this result in far better yields than bonds, but it can also add diversification to reduce risk in portfolios from both common stock and bond holdings.

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Disclosure: NBCUniversal and Comcast Ventures are investors in Acorns.