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:
- When bonds are riskier than stocks
- The Great Bond Diversification Myth
- Why would anyone have a mortgage and a bond portfolio?
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.
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.
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:
- Our emergency fund is exactly $0.00
- Why an emergency fund is a bad idea in one single chart
- Top 10 reasons for having an emergency fund – debunked (Part 1)
- Top 10 reasons for having an emergency fund – debunked (Part 2)
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.
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!
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!
“….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!
Thanks Fritz!
Yes, indeed we have many common interests! We should chat in person some time. I will reach out later via twitter message. 🙂
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.
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!
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.
Thanks for stopping by! Wow, you are brave having bought Preferreds in 2008/9!!! What broker do you use?
Thanks for the pointers!
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.
Oh wow! I have Fidelity too. And PFF is on the list of iShared ETF that trade at no commission at Fidelity!
Will check out individual Preferreds too. You got me intrigued now!!!
Cheers!
A new asset class for me to discover. Great!
I should actually start doing that as well. Park my money in some safer assets as collateral for options. Right now, it is a mess.
Thanks ATL. Though u don’t know how that kind of income in taxes in Belgium…
Cheers
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.
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!
I know you’ve mentioned moving towards a 2x leveraged option portfolio and implementing PFF as well as muni bond fund for your parked cash. Will the ~30% cash buffer decrease as you move to 2x leverage? Do you plan on replacing the muni bond fund entirely (eventually)?
Hi Caveman!
Yes, most definitely! I will likely cut the cash cushion by 1/3 to account for the lower margin requirements. I will wait and see what I should do with the Munis. In 2018 I will still be in a very high tax bracket. Potentially even in 2019 due to some deferred compensation packages that might be delayed until that year. Some of the Muni lots have capital gains of 10% and more and I would hate to realize them just to reshuffle the bond holdings. I will think more about the tradeoffs in 2019 or 2020!
Thanks for stopping by!
I am pretty late, but I think its worth pointing out that preferreds effectively have a very long duration which makes the yield less attractive that it seems (long duration bonds have higher yield than short duration bonds.) This combined with the extra credit risk makes the yield not super attractive.
I believe that financial corporations get more favorable tax treatment for holding preferreds, which makes me think that they may be less attractive for individual investors. Just like an individual in a low tax bracket shouldn’t own munis as the risk-adjusted yield is not as good as other options, an individual might find that the risk adjusted returns of preferreds are not as good as a basked of stocks and bonds. (and lets not conflate low vol for low risk)
Not sure what you mean by Financial hold preferreds. They probably hold some, but they are mostly the *issuers* of preferreds.
Also I don’t replace stocks with PFF. I merely keep the option trading margin cash there.
I think that the below article does a good job explaining why they are not as good of a deal as they appear: very subordinated, effectively very long duration, and an embedded call feature mean you are taking a lot more risk than is apparent in the low daily vol.
https://www.cbsnews.com/news/why-you-should-avoid-preferred-stocks/
mentioned near the end of the article, c-corps get a tax break when they own preferred shares in other corporations, which makes them attractive to insurance companies, etc. BRK is both an issuer and a holder of preferred stock, for example. Not sure how much of the market is owned by c-corps but I believe it’s substantial.
Another point since reading about your short option strategy: If being long stock is a bit like getting a free put with a strike of 0, then preferred stockholders are the ones who are actually selling those very far dated puts, so you are loading up on additional risk in an account that already has lots of exposure to extreme market events.
Have you thought about what happens to your portfolio if markets drop nearly 20% in one day as they did in 1987? I bet you not only loose on your options but your preferred take a beating as well.
I have to put the money somewhere. Bonds in general had a tough time. Whether it’s IEF or PFF, they suffer when the Fed raises rates. Even if I lose a bit on the principal, I can write that off through tax loss harvesting. Definitely beats holding 10Y Treasury bonds or T-bills on an after-tax return basis.
How are you feeling about preferreds now that we have seen Dec 2018 and the March 2020 crashes hit them almost as hard as SPY? The yield is nice, but it seems your margin cash level would be getting tested at the worst possible times when option premiums are through the roof.
Yeah, I noticed that! 🙂
I’m holding on to my preferred for now because they may be down a little bit for 2020, but they still have massive unrealized capital gains built in (because I did the tax loss harvesting around the bottom in 2018). So, I’m “kinda stuck”. But stuck with a 6% yielding asset is not so bad, right?
Thanks for the reply! Yeah, could certainly be worse than having a convenient high yielding asset that most of the time just makes cash flow higher without a ton of volatility. I’m in the boat where I’m holding most margin cash in ultra-short term bonds for a tiny 0.4% kicker to option writing. Considering muni stuff as you have, but it’s very hard to see the upside in bonds in general at the moment given the overall risk premium and considering moderately likely tax revenue issues coming up. I need to do a lot more reading up on it though.
I have to say that your work on this site is beyond appreciated; it is loved and you’ve made the world a better place having shared your knowledge.
Thanks for the kind words, Joel!
And again: the bond portfolio in my IB account doesn’t have to provide much growth. It’s just a bonus to supplement my put writing income! 🙂