Pimco's Buying Preferred Stock; Should Investors Be, Too?

Bond king Bill Gross' move into preferred stocks could act as a catalyst for an investment class struggling to regain its luster after the financial system collapse.

Traders work on the floor of the New York Stock Exchange.
Traders work on the floor of the New York Stock Exchange.

Pimco's somewhat surprising disclosure this week in a regulatory filing that it would be moving as much as 10 percent of its assets from the Pimco Total Return Fund into preferreds and convertibles is a relatively strong indictment against the bond market's prospects.

The move comes as high-grade bond funds saw record-high outflows of $2.5 billion last week and fixed income is on its way to its worst quarterly performance—a 3.8 percent loss—in more than a decade, according to Bank of America Merrill Lynch.

With Pimco holding more than $1 trillion in assets under management and its moves tracked closely by the market, its gyration into equities is likely to have ramifications.

"Pimco's statement that they are moving to or at least increasing their opportunity to go into those areas says they feel comfortable that as an asset class, preferreds will likely hold up better than bonds," says Sam Stovall, chief equity strategist at Standard & Poor's. "That's why they want to broaden their scope."

While the move is noteworthy, the company is moving gingerly.

The fund's portfolio won't contain more than 10 percent of equities, and it will hold no common stock, though the convertibles could be transferred at some point. That's about in line with what many portfolio managers recommend when it comes to preferreds.

"This is one component and shouldn't make up the entire portfolio," says Mitch Schlesinger, chief investment officer at FBB Capital Partners in Bethesda, Md. "You have to balance the higher yield against the higher volatility that you're going to get with these types of things...Pimco said 10 percent of their fund could be allocated to preferreds. That's the same level we're at and I think that's a relatively safe level."

Though preferreds are thought of as stocks, they actually function more like fixed income, providing yield and coupon payments and usually, though not always, with a set duration.

That means they are sensitive to interest rate movements, generally losing value when rates move higher, as they are likely to do. But strong coupon payments help offset capital losses, so preferreds can still generate return if held long enough even if rates do rise.

Average yields for preferred these days is above 7 percent, posing a nice opportunity for return.

"There's more risk in an instrument like a preferred in that it could function like the high-yield debt market," says Matt Havens, partner at Global Vision Advisors in Hingham, Mass. "If it's part of an overall strategy, maybe it's not too much risk."

Their sullied reputation came about following the collapse of the financial system in 2008 and 2009. With more than 80 percent of all preferred stock issued by banks and other financial institutions, the issues were especially hard-hit during the crisis.

But data Stovall compiled recently showed that over the course of the past eight years or so, preferreds have behaved more like stocks than bonds. Stocks and preferreds have moved in the same direction more than half the time, while preferreds and bonds moved together just 16 percent of the time.

With a slew of highly optimistic forecasts for stocks in 2011, that could mean a good opportunity for corporates.

"It really depends on one's view of the bond market and where you think long-term rates are going. We think rates are going higher but not substantially higher," Schlesinger says. "In terms of ongoing performance we don't think there's that much additional downside to preferreds as a group versus any other type of corporate bond exposure."

Schlesinger recommends investors try to stay out of bank-only preferreds, buying in real estate, utilities and other areas.

Among some of his recommendations for preferreds from Markel Corp and XCel Energy.

Investors looking to broaden the scope of their preferreds can use the popular iShares US Preferred Stock Index exchange-traded fund, which tracks the S&P Preferred Index.

"A high-yielding instrument such as preferreds will still in sense be taking it on the chin as interest rates rise," Stovall says. "But I don't think you're going to see the mass exodus from these preferreds as we are starting to see with bonds."