Getting the Market Right: Alexander Green on Preferred Equities

Steve McDonald
by Steve McDonald, Bond Strategist, The Oxford Club


Steve McDonald: Our guest this week is my favorite analyst, stock picker and investment guru.  And he’s been at this business almost 30 years.

Believe me when I tell you, this is the man you want to listen to. The Alex Green. Welcome, Alex.

Alexander Green: Thanks, Steve. I have to say, I’m a little bit embarrassed because it shows my age, but it’s been considerably more than 30 years.

SM: I had no idea. Okay.

The topic today is preferred stocks. It’s something I don’t think we’ve ever discussed in our videos. Where are they? How do you pick them? What do you like about them?

AG: Well, there are a number of things I like about preferred shares. I should begin by saying that probably most of our listeners know very little about them. I can tell you from my many years in the money management business that most people don’t own or have never owned a preferred stock.

That’s a shame because they offer excellent upside potential and limited downside risk, which is really what most investors are looking for.

So let’s begin by defining what a preferred share is. A preferred stock is a hybrid security. It’s like a stock in some ways, and it’s like a bond in some ways.

It’s like a stock in that it is equity in the company and it pays regular, quarterly dividends - but at a fixed rate. It’s not declared by the board of directors, but it has a fixed yield to it, and it trades in the market with daily liquidity like an individual stock.

Most preferred shares have no maturity date, just as stocks don’t have maturity dates. But like bonds, the yield is fixed and the interest rate is sensitive. So they go down when interest rates go up, and they go up when interest rates go down.

The great thing about preferred securities right now is that they yield a little more than 6%. And when you look at the S&P 500 yielding a little more than 2%, you’re looking at a fairly high yield. In fact, you’re looking at higher yields than even most non-investment grade bonds.

When you get into the junkier bonds, they can have high yields. But these are safer than junk bonds. They have high yields, daily liquidity and far less risk. These don’t fluctuate as much as common stocks because the yield supports them.

As a result, you’ve got equity-like returns with bond-like income and lower volatility. So that’s the case for preferred securities in a nutshell.

SM:  I have one question about the volatility. Are these the sorts of securities you buy that you will be able to sell at a capital gain, or is it strictly an income investment?

AG: Well, if you buy a bond, you might take a capital gain or a capital loss - the same as a stock. So is it the case with preferred shares. You could buy them and sell them for a profit down the road. Or if interest rates went up a great deal, you could end up selling them for a loss.

So there’s no guarantee. If you bought a bond at a discount to its face value, and it matured at its face value, you’d have a built-in gain there. But with preferred shares, you don’t really know.

It would depend on what the interest rate environment does because everything that’s yield oriented, whether you’re talking about utilities or bonds or real estate investment trusts, is going to be interest rate sensitive. Everyone’s comparing what they can get on certain securities with what the new interest rates are as they fluctuate.

It’s like a seesaw: As rates go up, prices come down - and vice versa.

We’re in a rising rate environment now, but we’re not in an aggressively rising rate environment. Few people see rates going to 5%, 6% or 7% anytime soon. As a result, preferred shares have a place in a diversified portfolio.

It’s not going to be the major component. You’re not going to put most of your money in preferred shares. But should you diversify into preferred stocks as a part of your portfolio? Absolutely.

SM: Now, can the company skip a dividend payment without declaring bankruptcy?

AG: No. First of all, the dividends are paid quarterly.

If they’re obligated to pay the dividend but suspend it, they have to suspend all common stock dividends until the preferred dividends are paid. And when they start up again, they have to repay the dividends that they missed - if they indeed missed any.

You can own these three ways. You can own the individual preferred stocks. For instance, JPMorgan and Bank of America both have preferred equities outstanding right now that yield more than 6%.

Or you could buy an exchange-traded fund, like the iShares U.S. Preferred Stock ETF (Nasdaq: PFF).

You could also buy closed-end funds that specialize in preferred securities.

Many of the best ones, Nuveen-sponsored funds, are trading at about a 7% discount to their net asset value. So they’re yielding the most of all, but they’re using some leverage, so they tend to be a little more volatile. You can buy individual preferreds, mutual funds, ETFs or closed-end funds.

SM: Great. So if you’re looking for income, and you want to have some upside potential as well, preferred shares look like a very good idea. Alex, as always, thank you so much for taking the time to be with us.

AG: Thanks for having me, Steve.

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P.S. Click here to see the latest investment opportunities Alexander Green has found for his subscribers.