The pros and cons of preferred stock
In many of my articles, I have recommended a balanced portfolio consisting of both common stocks and bonds, especially in or near retirement. In retirement, I have maintained a 50-50 ratio of stocks to bonds, in order to avoid significant fall in portfolio value during a bear market in stocks.
Bond investors have many options. When the Federal Reserve raises interest rates frequently, the value of long-term bonds will fall significantly in price. In my portfolio, at such times, I adjust my portfolio so that a significant part of my bond portfolio is not in long-term bonds, but in intermediate-term and short-term bonds.
I prefer investing in mutual funds or exchange-traded funds (ETFs) rather than individual bonds. In that way, I have a diversified portfolio and avoid the risk of, perhaps, selecting any company that may undergo unforeseen financial problems.
In addition, this minimizes fees, since mutual funds and ETF management are able to obtain lower fees than small individual bond investors.
What about preferred stocks?
In previous articles, I discussed the option of investing in preferred stocks as part of a bond portfolio. Preferred stocks combine elements of common stocks but are more like bonds.
They lack voting rights, but have a relatively high dividend, and they have precedence over common stocks. Investors receive a fixed payment stream.
They are commonly issued by major banks. Prices of preferred stocks are generally less volatile than common stock prices.
In a recent Barron’s article, Andrew Bary discussed some of the advantages of preferred stock investment at this time. Because interest rates have increased recently, many preferred stocks of major banks are now yielding close to 6 percent. Some preferred stocks issued by Real Estate Investment Trusts (REITs) are yielding about 7 percent.
The largest ETF specializing in preferred stock, iShares Preferred (PFF), now offers a yield of approximately 5.7 percent. I own some shares in PFF, which I purchased several years ago. PFF pays a dividend each month, which can be reinvested, which I do.
Bary pointed out in his article that one of the reasons why preferred stock is attractive now is because there is a widened gap between the interest rate for bank preferred stock versus Treasury securities with similar maturities.
However, preferred stocks are riskier than Treasury securities. No bank can guarantee interest payments equivalent to the guarantee of the U.S. Treasury.
Nobody can predict when the Fed will stop raising interest rates. If the Fed does continue to raise rates, interest rates will increase for many types of bond investments, including preferred stocks.
In the short-run, an increase in rates will result in a fall in the net asset value of PFF and other preferred stocks. [Ed.’s note: This is referred to as “interest rate risk.”] There is no guarantee that, in the short-run, your total return in PFF will be as high as 5.7 percent.
Less volatile, but some risk
Although a preferred stock investment will not be as volatile as common stock prices, there will always be interest rate risk associated with preferred stocks and other forms of bond investment.
The only way to avoid the interest rate risk associated with bonds is to invest only in short-term investments, such as Treasury bills, CDs and short-term bond funds. [Investments held to maturity are not subject to interest rate risk.] However, that strategy has the risk of not earning enough interest to stay ahead of inflation.
Many investors are understandably nervous about the recent volatility in the stock market. No one can predict whether we will be facing a bear market in the near-term, and how long will it last.
Prudent investors will maintain a balanced portfolio that includes some forms of bond investment. It makes sense to avoid investing too high a percentage in long-term bonds, and to maintain a portfolio that includes intermediate term holdings that will provide enough income to keep up with inflation, and not be subject to extreme interest-rate risks.
Elliot Raphaelson welcomes your questions and comments at email@example.com.
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