Preferred Stocks Gone Wild: Will You Be Safe Or Sorry?

March 04, 2009

Preferred stock yields have reached eye-popping levels. Are they too good to be true? At the very least, some caution is definitely in order.


Preferred stock yields have reached eye-popping levels that simply seem too good to be true.

As a result, a lot of income-oriented investors are taking a leap of faith and jumping into this very specialized corner of the market. And their attraction is obvious. Preferreds are yielding a whopping 15.4% on average right now.

But before you hop aboard the preferred love train, you might consider taking a step back and weighing both the risks and the benefits of this very unique type of security.

Confusing Views Muddle Picture

Fueling investor confusion is the fact that not even professional portfolio managers seem to agree on what sort of opportunity preferred stocks represent. There are just as many experts now lauding preferreds as great investment vehicles as those who suggest avoiding them like the plague.

In January, Flaherty & Crumrine, a California-based investment firm managing more than $2 billion in preferred investments, noted that "preferred securities are extremely attractive for long term investors."

Bill Gross, the Pimco bond guru, recently observed that bank preferred stocks are currently offering "remarkable 11-13% yields."

His startlingly succinct summary: "We [at Pimco] are buying bank preferred." Enough said.

Okay, but what say the cassandras? Their prevailing concern is that most preferred stocks are issued by troubled corporations in the financial sector. The greatest concentration of preferred issuers, in fact, is in the banking industry. Critics point out that many preferred stocks suffered losses 60-80% last year and there may be worse to come.

In addition to the risk of principal losses, others point to the growing risk of preferred dividend defaults. The naysayers mantra is a resounding, "Just say NO." They wouldn't touch preferred securities with a 10-foot pole.

Just The Facts

Preferred stocks blend the benefits (and risks) of both common stocks (equities) and bonds (debt), of the issuers. The $400 billion preferred securities market is spread over almost every industry group, but is concentrated nearly 80% in the financial sector alone.

Dividends may be fixed, adjustable or determined by periodic auctions (auction rate preferreds). The dividend is not guaranteed, but must be paid before common stockholders receive their dividends. Some investors select so-called cumulative preferred stocks because these unique securities must eventually repay any dividends which have been omitted during the investor's holding period.

Should a corporation declare bankruptcy, preferred shareholders have a "senior claim" over common stockholders. In such cases, the bankrupt company first must satisfy all back taxes and secured creditors, then bond holders, then preferred shareholders, and finally common stockholders.

Preferred stocks are segregated into two types. "Traditional preferred stocks" are equities and qualify for the favorable 15% dividend tax rate. "Trust preferred stocks" are considered to be debt securities and their dividends are taxed at the higher ordinary income tax rate.

Trust preferreds are currently considered safer than traditional preferred stocks and consequently trade at higher prices. They are also senior to the newly issued government "TARP preferreds."

If presented a choice, a more cautious investor will chose trust preferred over traditional preferred stocks.

A Bumpy Ride

The volatility in preferred stock prices has been breathtaking in the past year. Sharp sell-offs averaging 42% have occurred on four occasions since summer 2008. Equally stunning rallies exceeding 59% have immediately followed each collapse.

The Lehmann bankruptcy in mid-September 2008 kicked off the first stop along this jolting preferred "bi-polar express" ride. Optimism for a potential Federal Reserve rescue plan provided a late September relief rally of nearly 54%. The credit gridlock, caused by historically high LIBOR spreads, quickly plunged preferreds into a 47% mid-October abyss.

Hopes of quick government bailouts and pre-TARP discussions sparked yet a third rally of 64% into the early November 2008 peak. Congressional bickering, causing delays in crafting a workable TARP agreement, crushed preferred stocks again by nearly 35% into the November 20 low.

Then came the December "Obama honeymoon," as well as a completed TARP agreement, igniting a massive 59% rally into early January 2009.

In the past 60 days, preferred stocks have suffered yet another 44% sell-off in the face of mounting fears that the U.S. government may nationalize major banks.

So where do preferred stocks go from here? If short-term history is any guide, an imminent rally of 50-60% might be a reasonable guess.

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