An addition to the ERN family portfolio: Preferred Stocks

Last year in December we noticed that one of our Municipal Bond mutual funds had short-term losses. That’s not a huge surprise after the post-election bond yield surge and hence it was time to harvest those losses. If you’re not familiar with Tax Loss Harvesting, we wrote two earlier posts on the topic, one dealing with the general concept and one dealing with the implementation. In any case, after we sold the underwater tax lots, where do we put the money? For 30 days we can’t invest in the same fund (or different fund with identical benchmark) or we’d run afoul with the IRS wash-sale rule. There was one asset class that we had never owned but had definitely been on our radar screen for a while. Finally, we took the plunge and invested in… drumroll …

Preferred Stocks!

A primer on Preferred Stocks

Preferred Stocks have features from both stocks and bonds:

  • Preferreds pay a dividend like a common stock, but the dividend is normally fixed like a bond interest rate and sometimes a floating rate tied to a benchmark interest rate (e.g. LIBOR+x%).
  • You can get higher yields on preferreds but also face more risk. Specifically, in case of a liquidation (bankruptcy), the payment to preferreds holders is subordinated to the bond holders. But Preferred investors take seniority over the common stockholders.
  • Retail investors normally buy Preferreds through a fund or ETF. I consider myself a pretty savvy investor with experience in equities, options and futures trading, but I have never traded an individual preferred stock. I don’t even know any ticker for any preferreds. If any of you do, please share your experience below about trading costs and bid-ask spreads because the expense ratios of all the ETFs I found were quite high!
  • Preferred Stock investors normally have no voting rights, so in that sense, they are closer to bonds than common stocks.

Some more background on our bond investments

Some of you probably thought, hey ERN, aren’t you the big bond-curmudgeon? Why would you hold bonds after writing all those nasty posts trashing bonds:

OK, here’s the background: There is one part of our portfolio where we hold bonds out of necessity. For our options trading strategy, we need to hold a certain amount of money in margin cash. We could theoretically hold this in equities, but since the option strategy has the potential for some very ugly leveraged downside risk, we thought it would be prudent to not double-dip in the equity risk bucket and rather hold bonds as a margin cushion. Muni bonds with their tax-free interest and an even slightly negative correlation with equities seemed like a good fit. Most of the tax lots have sizeable gains but some of the new investments in 2016 had losses large enough to be harvested. We needed to find a replacement for them!

What Preferred ETF did we buy?

We bought the iShares ETF (PFF) and here are some of the stats:

  • Price: $38.72, as of 2/24/2017.
  • Expense Ratio: 0.47%. Ouch! That’s why we’d be really interested if anyone has experience trading individual Preferreds to save that massive drag on yield!
  • Current dividend yield: 6.41% (most recent distribution), 5.53% (30-day SEC yield), 5.72% (12-month rolling distributions vs. most recent price), as of January 31, 2017
  • 5 largest sectors: Banks (41.9%), Diversified Financial (19.1%), Real Estate (10.9%), Insurance (9.2%), Telecommunication (3.4%). As of 12/31/2016
  • Standard Deviation (3Y): 4.35%, Equity Beta (3Y, monthly): 0.21, as of 1/31/2017

Disclaimer: We have no business or other relationship with the issuer iShares.

What we like about Preferred Stocks

First, the yield is phenomenal! Currently, PFF pays a yield of over 5.7% p.a. What’s more, most of that yield (68.36%) is considered a qualified dividend, according to iShares, and taxed at the lower (potentially zero) federal income tax rate (same as long-term capital gains). The gross yield of the Preferreds ETF is actually higher than that of the iShares High-Yield ETF (ticker: HYG) as of 2/28/2017. Even better, the after-tax yield difference is even wider because the high-yield bond interest is considered ordinary income and taxed at a much higher rate. Recall, our options trading account is a taxable account so we don’t have the benefit of holding bonds in a tax-deferred account.

Second, we’re preparing to retire in 2018 and will likely have a much lower marginal tax starting in 2019. Eventually, we will have to shift out of the Muni bonds in this account because their after-tax yield will be too low relative to some of the taxable bond and preferred stock alternatives. We might as well start that transition now.

Third, like all investors, we’re obviously concerned about bond returns in a rising interest rate environment. All the yield-chasing during the last few years came to an abrupt halt after the U.S. 10-Year Treasury yield surged to around 2.5% in December. Preferreds are not immune from rising interest rates, of course, but there is one nice feature that might at least cushion the fall: The large exposure to financials. Financial stocks benefit a least somewhat from higher interest rates. It’s not just a statistical artifact but banks actually make more money when interest rates (and spreads) are higher.

Fourth, we like the relatively low volatility of only about 4% p.a. (but see the caveat below). Sure, we could invest in some high-yielding REITs or junk bonds with a yield in a similar ballpark, but they would also have extremely high volatility. Remember, we are looking for a way to invest a big chunk of margin funds that are used as collateral for our futures and options on futures transactions.

What we don’t like about Preferred Stocks

First, Preferreds did horribly during the global financial crisis. In fact, the price of the ETF is still underwater when compared to the pre-crisis price quotes. Though, when factoring in dividend reinvestments you did generate a small positive return (about 4% p.a.). So, a bet on Preferreds is a bet on the next market downturn not being as cruel to financial stocks as the 2008/9 recession. Is that a bet worth taking? We think so! Avoiding Preferreds now is like closing the barn door after the horses have left. The next recession will be different.

PreferredETF-Chart1.png

Second, in contrast to common stocks, there is relatively little upside potential in Preferreds. At 5.7% yield plus some downside risk due to further interest rate hikes, this is not an asset class that will shoot the moon. If you are not already close to Financial Independence, Preferreds will not get you there very quickly. Look at the cumulative return chart below: Equities and Preferreds both took a hit during the 2008/9 crisis. They both recovered, but during the last few years Preferred lagged behind. Also notice that while Preferreds and bonds seem very correlated in the 2012-2017 time span, they behaved very differently in 2008/9. Bonds offered some diversification, Preferreds didn’t.

preferredetf-chart2
Cumulative returns of PFF (Preferred Stock ETF), VTI (U.S. Total Stock Market ETF) and IEF (7-10Y U.S. Treasury Bond ETF). since 2007. Dividends/Interest reinvested.

But then again, Preferreds in our portfolio have a very low bar to cross because we make the bulk of our returns shorting put options on S&P500 futures. The way I see it, even if the price drops by 5.7% (=dividend yield) we still come out ahead because we can use tax loss harvesting and write off the loss at the higher ordinary income tax rate while generating the majority of the dividends taxed at a lower marginal rate.

How did they do so far?

The performance so far was better than we expected! We bought two lots of 1,000 shares each on December 27 and 28 at an average price of $37.16 and the ETF has since climbed to over $38.70 (as of 3/1/2017) and paid a $0.19 dividend on February 1 and another dividend (TBA) today on March 1. That’s much better than the performance of the Muni bond fund we sold. Better be lucky than smart!

Other uses of Preferred Stocks

Cash buffer in retirement: We are planning to give more details on our precise investment strategy in retirement in an upcoming post. For now, we can reveal that we will likely keep several months worth of expenses outside of stocks to avoid having to withdraw from the stock portfolio at an inopportune time. Preferred stocks might be a good place to “park” that money with a high enough yield and low enough volatility. And again, this assumes we don’t get into another recession that brings the U.S. financial sector to the brink of extinction.

Emergency Fund: OK, here’s Mr. ERN in the mood for breaking another taboo. We obviously don’t like the Emergency Fund too much and have written about it extensively:

But our main reason for not having a designated EF was the low yield in money market accounts. If we can juice up the return of that account we have just reduced the opportunity cost of the emergency fund.

Conclusion

We thought we should share our experience with our new asset class. To be sure, Preferreds are not for everybody. But if you are willing to look past the horrendous performance of Preferreds during 2008/9 you might like this as an attractive investment option.

Disclaimer:

Just to be sure, this is not investment advice, just food for thought. We have no business relationship with the ETF vendors mentioned here. Please read the general Disclaimer Page as well.

Have you had experience with Preferred Stocks? Please share your thoughts below. Looking forward to your comments and suggestions!

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16 thoughts on “An addition to the ERN family portfolio: Preferred Stocks

  1. That’s Murphy’s Law of blogging: The day you post this the ETF is down by 0.3%. Not much in absolute terms but compared to the normal daily volatility that’s substantial!
    But still an interesting post! I will put this one on my watch-list!

    Liked by 1 person

    • Ha, that’s funny. I was afraid the fund will tank exactly today when I post this. But today is the ex dividend date for the ETF (see here)
      So the ETF is down $0.08 but you’ll receive the $0.19 dividend. Which is a net gain! That’s crazy considering that bonds got hammered today. The 10-year yield went up by 10bps!
      This goes to show that PFF can actually do well in a rising rate environment thanks to the Financial sector exposure!

      Like

  2. “….we thought it would be prudent to not double-dip in the equity risk bucket and rather hold bonds as a margin cushion.”

    – A Great example of why you’re such a fantastic blogger. You really think about these things, and you’re good at it. (I, too, have a margin account, and I’ve never thought about the asset allocation as you’ve done in this post). I love your insight, and your mathematical abilities. Great stuff!

    Ironically, I also own PFF, Muni’s, and have an option trading strategy. We’re very similar in our thinking. Hope we can meet in person sometime, would be cool to chat. Maybe FinCon?

    Keep Up With The Great Stuff!

    Liked by 1 person

  3. I have long disregarded preferred stocks as an asset class since my impression was that you got the worst of both worlds, i.e. limited upside of a bond holder but without as much seniority, while taking on similar downside risk as a common share holder owning equity.

    Also, as you mentioned, I wouldn’t have the first clue about where to buy any.

    0.47% is high compared to a lot of ETFs but isn’t too bad considering they’re dealing in securities you wouldn’t know where to get on your own.

    Curious what muni bond funds you use. I’ve leaned towards CEFs because you can get them at a discount to NAV and all the ETFs seem to have a direct correlation between yield and duration. The active guys seem to “earn their keep” in this space in the sense that they can use leverage and active management to boost yield at lower effective durations…but 50 basis points would be a screaming deal for anything in the 5%+ yield range.

    I appreciate this post, and I will not be so closed minded about preferred stocks as a result.

    Liked by 1 person

    • Thanks!
      I hold Muni bonds through a Mutual Fund that’s tax-free for both federal and state taxes. I live in a high-tax state, so that’s very important.
      I like the CEFs (Closed End Funds), but they also tend to have high fees, and higher volatility (some of them use leverage). Also, the NAV discount is nice, but if it never converges back to zero by the time I sell, I gain nothing from it (except maybe a very slight leverage factor at no extra cost). But you are right: I have the Muni CEFs on my watch-list. Might use them to supplement my holdings.

      Also, for the record again: Preferreds are not set up to generate lots of growth. So I agree with the worst of both worlds assessment. But as a cash alternative they are the best of both worlds: High-yield-like income, but from companies that are actually solid (JP Morgan, Wells Fargo) rather than the crummy junk bond companies. I’d rather have secondary seniority of a company that never goes bust than first seniority of a junk bond. 🙂
      Cheers!

      Like

  4. I bought my first Preferred stock (individual issues) during 2008/2009 when some issues were offering a yield on cost of over 15%. Not a large investment. Since all of the purchases have subsequently been called away by the issuer, I got my share of sad times. 🙂 The market prices were just insane at the time compared to the risk of loss of principal.

    I currently hold two Preferred issues. You can find issues paying qualified dividends which offer a reasonable real rate of return if you hold the issue until called… with the qualification that you may be holding the issue for a very long time. If you are worried about interest rate risk, then there are floating Preferred issues out there, but current prices don’t seem that attractive to me.

    Liked by 1 person

      • I use Fidelity and I had no more than 30K committed to variety of Preferreds issued by LARGE REITs. At less than 50% of PAR value, I figured a lot has to go wrong with the stock before I would be at risk for loss of principal. To my knowledge, only General Growth Properties among LARGE REITs went into bankruptcy during this period although more than a few REITS suspended dividends for a time.

        Obviously, if the investment had turned out badly, then I would actively being forgetting the whole affair. Looking at my records, the last issue that was called on me was Prologis, Series P, purchased 03/20/09 at $12.40 and called on 04/19/13 at PAR. Dumb luck is better than no luck.

        Oddly enough, I also purchased PFF for a few months last year to hold some cash. I have no debts and I sell naked Puts (usually out of the money, sometimes well out of the money) to gain a little leverage. Strictly small scale compared to your own efforts, but I try to avoid any margin balances and having a quick source of cash is useful.

        Liked by 1 person

  5. It would be interesting to see the pff vti ief plot during the 2000 bear market since it was led by tech and not financial. The ETFs may not have existed but maybe there are benchmarks that could be used. Or any other stock market decline that wasn’t due to financials.

    Liked by 1 person

    • That’s exactly one my mind too. But PFF started only in 2007 and even its benchmark index doesn’t go back before 2007. I also looked for any other index I could find on Bloomberg but there’s nothing with coverage all the way back to 2000.
      Does anybody have any suggestions for how to check how Preferreds performed before 2007? Ideally in a garden-variety recession like 1991. Thanks!

      Like

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