Boost your portfolio income with this hybrid asset. Just be aware of the recession risk

Published Thu, Feb 16 202310:02 AM EST

For yield-hungry investors, preferred stocks offer a way to boost portfolio income. But they'll need to be vigilant as fears of an eventual recession ramp up. Preferred stocks are a hybrid asset. Like stocks, many of them trade on exchanges. Like bonds, they offer a stream of income, but do so quarterly rather than semiannually. They have yields, which move inversely to the value of the preferred stock – the same way bonds do. But just because preferred stocks share some attributes with bonds doesn't mean they have the same risk profile as the other components of your fixed-income sleeve. "The benefit is that they pay more income than bonds," said Jordan Benold, a certified financial planner at Benold Financial Planning. "However, with bond yields rising, the place for preferred stock in a portfolio should be used sparingly." Risk characteristics Since the Federal Reserve kicked off its inflation-fighting campaign last March, boosting interest rates eight times, bond yields have jumped. That's presented a buying opportunity for fixed-income investors seeking safe yields at lower prices. US1Y US2Y,US5Y 1Y line Yields on U.S. Treasurys are higher as the Federal Reserve has embarked on its policy-tightening campaign. For those who want to stretch for yield and take on a little more risk, preferred stocks are another attractive possibility. This is also the case in the event the Fed looks toward backing off of rate hikes. "As the Fed begins to reach the end of its tightening cycle and rates become more range-bound, we think there's an opportunity in preferreds to add income," said Michael Arone, chief investment strategist for the U.S. SPDR business at State Street Global Advisors Preferred shares generally have a fixed par value of $25, and typically make quarterly income payments to investors. They also have either no maturity date or a very long maturity date – say, one that goes out 30 years – but many of them have a call date, at which time the issuing company can redeem them. This is where the risk comes in. For instance, the lengthy maturity of these instruments means that they are more sensitive to rising interest rates, and that means the market value of the preferred shares will decline. Here's another risk factor: Investors need to be aware of the financial strength of the issuer. But many of these securities are rated by credit monitoring agencies, including Standard & Poor's and Moody's Investors Services. Financial services firms are among the major issuers of these securities, so if you buy individual preferred shares, you could be bulking up on portfolio exposure to banks and insurance companies – and you may be ramping up risk in the event of a severe recession. "If in fact we have a deeper-than-anticipated recession and people get nervous about financial companies' balance sheets, that can pose a risk," said Arone. "Our view is that those risks are worth taking in order to capture income in an investment-grade asset." Finally, in the most extreme cases, companies can also change or suspend payments on preferred stock if they are struggling to make the payments. That can disrupt your income stream if you were counting on those payments to land in your portfolio. Pinpointing exposure Due to the unique risks in preferreds, financial advisors recommend adding them sparingly to your portfolio. Benold recommends a range between 5% to 10% of a portfolio in these securities. He also prefers using exchange-traded funds to diversify among issuers of preferred shares. "You can use some preferred stocks from individual companies – some real estate companies, for instance – but if you put money in the stock and the company goes bankrupt, you're up the creek," Benold said. "We like a diverse pool of different preferreds." Two of the funds he uses are iShares Preferred and Income Securities ETF (PFF) and Innovator S & P Investment Grade Preferred ETF (EPRF) . PFF offers a 30-day SEC yield of 5.92%, while EPRF's 30-day SEC yield is 5.36%. How much of your portfolio you'd like to commit to preferred shares will also depend on your needs as an investor, as well as your risk appetite. For starters, individual preferred shares aren't great for price appreciation. But they do offer income for older investors who prioritize a steady payout over runaway growth. "If the client is looking for certainty and stability in cash flow, preferred stock could be one vehicle they could use as part of a diversified portfolio," said Jay Spector, partner at Barton Spector Wealth Strategies.