Preferred stocks are hybrid securities that contain features of both bonds and equities. Like bonds, they pay dividends according to a rule, usually a rate set at issuance but occasionally a floating rate (e.g. LIBOR + spread), are rated by credit rating agencies, and are affected by changes in interest rates. Like equities, they have the potential for capital appreciation, although less than common stock, and receive favorable tax treatment on their dividends. Additionally, in the case of a company’s bankruptcy, preferred security owners’ claim on the liquidation is higher than common stockholders but lower than bondholders. These features make preferreds different enough from standard equity and bond holdings to play a unique, valuable role in a portfolio.

Types of Preferreds

Preferreds come in a variety of types; the most common is the fixed rate perpetual (or straight) preferred. This security is issued with no maturity date and pays a fixed dividend until it is called by the issuer. The next most common pays a fixed dividend and has a specified maturity date. If the security makes it to that date with no call or bankruptcy, the holder will receive face value either in cash or in common stock.

The third type of preferred pays a floating rate dividend, which can be beneficial as rates begin to climb. The final primary type is the convertible preferred, which can be exchanged for shares of common stock in a preset ratio.

Regardless of type, the position of preferreds on the corporate finance ladder means that they are entitled to dividend payments before common stock holders, but after bondholders receive their coupons. However, as long as a company does not pay common stock dividends, they can also skip dividend payments on preferreds without triggering a default. In this case, a cumulative preferred will accrue these skipped dividends to be paid at a later date; a noncumulative preferred will be out of luck.

Preferred Stock ETFs

With the proliferation of ETFs in the market, there are options for investors to gain exposure to preferreds without taking on excess credit risk. Three preferred stock ETFs currently have over $1 billion in assets: the iShares S&P U.S. Preferred Stock Index Fund ETF (PFF), the PowerShares Preferred Portfolio ETF (PGX), and the PowerShares Financial Preferred Portfolio ETF (PGF).

PGF is comprised of 100% financial preferred stocks whereas PFF and PGX track more diversified indices. However, PFF and PGX both currently hold over 85% of their portfolios in Financials, a fact that is not surprising since certain preferred securities may be counted toward capital requirements for banks. These ETFs hold the remainder in some combination of Industrials, Real Estate and Utilities.

Even with the similarities in sector concentrations in the broader preferred ETFs, PGX and PFF still have their differences. PFF currently has 50% more holdings that PGX. PGX screens for credit quality while PFF does not. If it still seems like a toss-up between the two, PFF and PGX trade commission free on Fidelity and Charles Schwab, respectively. But before making the decision of which to use, why should preferreds be in a portfolio in the first place?

Preferreds in an Outcome Oriented Portfolio

We strongly advocate for constructing portfolios to achieve specific goals. Traditionally, dividend stocks have been a primary asset to boost portfolio income; adding preferreds to the allocation could potentially increase income with the added benefit of diversification.

Using daily data over the past seven years, PFF has a correlation of 0.58 to stocks (SPY) and 0.13 to bonds (AGG), whereas the Vanguard High Dividend Yield ETF (VYM) has a correlation of 0.95 to stocks and -0.20 to bonds. As a point of reference, stocks and bonds had a correlation of -0.11.

We can see further motivation to add preferreds to an income portfolio when we examine the relative yields and volatilities of preferreds and dividend stocks. The chart below shows the yield and volatility ratios of PFF to VYM.

Preferred stocks

Over the entire period, the relative yield of preferreds to that of dividend stocks is higher than the ratio of the volatilities, a measure of the relative risk. Dividend stocks have more potential for capital appreciation, which would explain some of this difference in yield to risk, but as far as income is concerned, preferreds are a strong performer.

The Effect of Rising Rates

Because preferreds share similarities with bonds, they are also affected by interest rate fluctuations; that is, they have duration. For a given fixed rate preferred, higher interest rates will generally cause the price to drop.   This price drop becomes larger as the maturity date on the preferred is increased. Thus, perpetual preferreds are the most sensitive to interest rate changes. Floating rate preferreds will have their rates adjusted periodically as rates increase, which can mitigate the price impact.

If an interest rate increase stems from an improving economy, the equity characteristics of preferreds can shine through to offset the duration based price decreases as rates climb. A strong economy not only causes common stock price appreciation, which is why convertible preferred prices are also mainly driven by these equity characteristics, but also reduces the risk of bankruptcies and promotes tighter credit spreads.

The largest preferred stock ETFs are comprised mostly of perpetual preferreds followed by fixed rate preferreds with a maturity date. As such, these ETFs will be exposed to some degree of duration risk. Ultimately, the state of the economy, predominantly the financial sector, will determine how much of that risk will be realized.

Our View

Preferreds are like higher yielding, lower volatility dividend stocks that are exposed to interest rate risk. This risk is more pronounced for preferreds of longer maturity, but with the continued bull market and no immediate signs of a recession, equity appreciation is likely to offset some of the duration risk.

While individual preferred shares are not extremely liquid, packaging them as an ETF adds secondary liquidity, making preferreds highly accessible to investors of all sizes. Based on the current yields of preferreds relative to their volatilities, there is an opportunity to complement dividend stocks to diversify and possibly increase portfolio income.

For explanations of some other income generating asset classes, see our posts on Bank Loans, convertible bonds, buy-writes, put-writes and MLPs.

Note: Newfound utilizes the iShares S&P U.S. Preferred Stock Index Fund ETF (PFF) in its Newfound Multi-Asset Income strategy.  Newfound encourages investors to seek the advice of a financial advisor as the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

Nathan is a Vice President at Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Nathan is responsible for investment research, strategy development, and supporting the portfolio management team.

Prior to joining Newfound, he was a chemical engineer at URS, a global engineering firm in the oil, natural gas, and biofuels industry where he was responsible for process simulation development, project economic analysis, and the creation of in-house software.

Nathan holds a Master of Science in Computational Finance from Carnegie Mellon University and graduated summa cum laude from Case Western Reserve University with a Bachelor of Science in Chemical Engineering and a minor in Mathematics.