Should You Prefer Preferreds?

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When it comes to investing, you’ve no doubt come across the two main areas of asset allocation:  stocks and bonds.  Each offers its own characteristics, with equities providing a likelihood of greater gains over time, while bonds generally offer higher income and lower volatility.  What you might not know is that there is a separate asset class known as preferred stocks, which adopt a mixture of characteristics from bonds and equities.

Preferred stock is commonly known as a blend between debt and equity on the capital structure.  Preferred stock receives coupon payments ahead of equity holders and usually has higher interest rates than the dividends on a company’s common stock.  Preferred stockholders do not have voting rights that common stockholders do.  Furthermore, while bondholders are the very first to have claim on a company’s cash flows, preferred securities generally yield more than a company’s bonds.

The rush for yield

It’s been well publicized that income-seekers are up against the wall.  The Federal Reserve’s policy of zero short-term interest rates has resulted in standard fixed income securities, such as certificates of deposit and savings accounts, yielding almost nothing.  The double whammy of historically low rates and inflated asset prices has left investors disappointed by traditionally higher-yielding asset classes.  High-yield bond funds, more commonly referred to as junk bonds, only offer yields of 5% or 6%, which isn’t appreciably higher than the dividends on some of the market’s highest-yielding stocks.  For investors interested in greater income than bonds provide but don’t want to expose themselves to the additional market risk of equities, preferred stocks may be the way to go.   

ETF’s to the rescue

Thanks to the rapidly growing popularity of exchange-traded funds (ETF’s), which hold baskets of securities like a mutual fund but trade throughout the day, it’s now possible for investors to gain exposure to the preferred stock asset class without having to search too far.  John Hancock, iShares, and PowerShares each rolled out exchange-traded funds of preferred securities. 

It’s worth noting that the holdings of preferred stock funds such as the ones in this article are heavily allocated toward the financial sector, since preferred stock is predominantly issued by financial institutions.  More than half of the John Hancock Preferred Income Fund’s (NYSE: HPI) holdings are derived from the financial sector.  The closed-end fund trades slightly above its net asset value and yields more than 7.25% at recent prices.

The iShares U.S. Preferred Stock Index (NYSEMKT: PFF) and PowerShares Financial Preferred (NYSEMKT: PGF) exchange-traded funds are 100% allocated to the financial sector and yield 6% and 6.3%, respectively.

An additional benefit to preferred stock funds is their reduced volatility.  For investors unable to stomach the wild swings in the market, these funds allow for greater yields than most stocks with the benefit of lower volatility.  The John Hancock Preferred Income Fund has traded within a range of $21 per share to $24 per share since the end of 2011.  Furthermore, both the iShares U.S. Preferred Stock Index and the PowerShares Financial Preferred funds hold three-year average betas of less than 0.5, meaning that for every 1% in the markets, these funds will move by less than 0.5% in the same direction.

The Foolish takeaway

Preferred stock offers investors a convenient blend of debt and equity characteristics.  For investors who rely on income from their investments, preferred stock funds such as these provide dependable income with yields greater than both stocks and bonds in the current environment.

Preferred stock holds a superior position to common stock on the capital structure, and can allow for more capital gain potential than bonds.  For investors under-allocated to the financial sector who don’t want to outright buy bank stocks, these funds might be perfect for you.  Each of these funds has shown reliable performance and offers compelling yields in an investing environment of historically-low interest rates.  If you're sick of earning almost nothing from savings accounts and certificates of deposit but don't want to expose yourself to the same level of risk of the stock market, preferred stock funds such as these should be on your list.

rciura has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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