These assets have yields not seen in years — here’s what to know about preferred stocks

Published Tue, Nov 29 202210:47 AM ESTUpdated Tue, Nov 29 202210:54 AM EST

Investors looking for income in this market may want to consider preferred stocks. The asset has characteristics of both stocks and bonds — they trade on exchanges like stocks but they have a face value and pay dividends like bonds. They are also like bonds in that when the value of the preferred equity goes down, yields rise. However, they typically offer a higher yield than other fixed income products and can have more risk. The securities typically have a par value of $25 per share. "They look attractive on both a relative and an absolute basis; absolute if you compare them to corporate and municipal bonds, they have a very strong yield. Also relative to the past, they are trading at a higher yield than they have for the last 10 years," said JR Humphreys, senior portfolio manager with Sheaff Brock Investment Advisors. Preferred stocks have had a rough year. The ICE BofA Fixed Rate Preferred Securities index, which tracks the performance of fixed-rate preferred securities, is down 13.06% year to date, as of Monday's close. Its yield is over 7%. The only other time the yield on the index spiked over 7% in the last decade was March 2020. "We are probably nearing the end of the Fed rate hikes and unless we have a very severe recession, preferreds should do fine," he said. Humphreys, who owns preferred equities in funds he manages, is expecting better performance in 2023. Whenever preferred stocks have a negative year, they tend to have a strong performance the following year, with the exception of the financial crisis in 2007 and 2008, he said. For instance, the last down year was in 2018, when the ICE BofA Fixed Rate Preferred Securities index lost 4.3%. In 2019, it gained 17.7%. After 2008's 25.2% loss, it bounced back 20.1% in 2009 and after 1999's 4.4% slide, it rallied 16.2% in 2000, Humphrey said. He said he doesn't anticipate the double down year like 2007 and 2008, since that was due in part to the disruption of the financial crisis. What to know The securities can be complicated, which is why experts suggest using a financial advisor. Fixed-rate preferred equities tend to dominate the market for individual investors, said Collin Martin, fixed income strategist for the Schwab Center for Financial Research. However, some have floating rates and others have fixed-to-floating rates that switch from fixed to floating after a certain period of time. Preferred stocks also tend to have long maturity dates, like 30 years or more, or no maturity date at all. However, most have a call date, which is when the issuer can redeem the asset. Because of that, the investment is a long-term one, Martin said. There is also not necessarily a lot of liquidity, noted Tim Ghriskey, senior portfolio strategist at investment management firm Ingalls & Snyder. "They are not all created equal," he said. "Trading is thin so a big seller or big buyer can really move the price." The ones that are less liquid should be avoided, although there are plenty of relatively liquid ones that trade enough, he said. Preferred stocks vs. bonds While preferred stocks have yields around 7%, corporate bond yields are closer to 5.5% on average, Schwab's Martin pointed out. However, preferred stocks come with more risk. For one, corporate bond debt is paid off before preferred shares in the event of bankruptcy. Buying a good company can mitigate some of the capital structure risk, said Sheaff Brock's Humphreys. "You're buying the same investment grade company but you are picking up an additional spread by just being lower on the balance sheet or taking a subordinated debt versus the senior. You pick up extra yield for doing that," he said. However, there is also a lot of volatility. For that reason, Martin said he believes they are meant for moderate to aggressive investors. "They tend to be more sensitive to what's going on in the market — whether it is a fluctuation in interest rates or the market," he said. "Yields are attractive, the entry point is attractive, but you have to be ready to ride up the ups and downs." Yet for Humphrey, the income is worth it. "Will there be volatility in the short term? Probably," he said. "You are getting 7% [yield] right now. That will help prevent some of the downside." Tax advantages There are also potential tax advantages to buying preferred shares over corporate bonds. Look for those that have qualified dividends, which are taxed as long-term capital gains , Ghriskey said. Single filers who have taxable income between $44,626 and $492,300 have a 15% rate for 2023, while those who have less income pay nothing and those who have more pay 20%. For married couples filing jointly, those who make $89,251 to $553,850 have a 15% rate next year. Bonds, on the other hand, are generally subject to ordinary income tax , which is higher. How to invest If you want to invest in preferred equities, consider it a part of your fixed income portfolio, Ghriskey said. "Since bonds are used to protect capital rather than grow capital, you should take that into account when you're building a fixed income portfolio," he said. "So the preferreds simply become a kicker." The rule of thumb is to keep preferred stocks to about a quarter to a third of your fixed income portfolio, he added. You can buy preferred stocks just like you would regular stocks, through a broker or brokerage firm. You can also invest in funds, like the iShares Preferred & Income Securities ETF or the Cohen & Steers Preferred Securities and Income Fund , to get some diversity. Ghriskey likes investing directly in the securities rather than a fund, since you know what company you are buying and you aren't paying any extra fees. With financial institutions making up a large part of the preferred market, he would suggest looking at names like Citigroup, Goldman Sachs and Morgan Stanley. "Stay with the big names," Ghriskey said. "There is less chance of any problems." If you are investing in a fund, consider one that is actively managed since it is such a niche market with different asset structures, Humphreys advised. In his funds, Humphreys has Wesbanco preferred stock, which yields 6.68% on the $25 par value. It is callable until Nov. 15, 2025, and if it isn't called by that date, the rate then floats at the 5-year Treasury rate plus 6.55%. He also holds PacWest Bancorp, which has a 7.57% yield on its preferred stock. It's callable until Sept. 1, 2027. If it is not called at that time, then the yield will float at the 5-year Treasury rate plus 4.82%, he said. Both names are less sensitive to interest rates and should perform better as rates increase, he added. Lastly, Pebblebrook Hotel Series G preferred shares, yielding 6.375% on the $25 par value, is a good name for when interest rates start to decrease, Humphreys said. There is no reset on the rate on the call date of May 13, 2026, which essentially lengthens its duration. As a result, the security is more sensitive to interest rate movement, he said.