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Aug. 12, 2016, 1:11 p.m. EDT

Why I decided to give preferred stocks another look

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About John Gerard Lewis

John Gerard Lewis manages the Stable High Yield model on Covestor, an online marketplace for investment management. He is founder and president of Gerard Wealth Management, a fee-based registered investment adviser based in Olathe, KS. John holds a Bachelor's Degree in Business Administration from Kansas State University and did graduate studies at the University of Dallas and Rockhurst University.

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By John Gerard Lewis

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I'm not crazy about preferred stocks and probably wouldn't buy them at all if intermediate-term bonds were more attractive at the moment. Preferreds do have attractive yields, and while some are tantamount to junk bonds, others are issued by high-quality businesses, many of which happen to be financial concerns.

My fundamental reluctance is that most preferreds don't mature at par on a date certain, which means that one invests in them without the assurance that, barring default, the par value will be returned fully intact at a specified time in the future.

Therefore, unlike bonds, you generally can't buy preferreds on the premise that: "Interim price swings don't matter, because I'll hold them to maturity and so be repaid the par value." Most preferreds have no maturity date. You'll either hold them forever, sell at the market price, or relinquish them to the issuer if they're called — and in any of these cases you might take a loss.

Indeed, when buying preferreds, the call terms are paramount, and you can suffer a net loss if the stock is called before you cross your positive yield-to-call date.

For example, on the date of this writing, the Consumers Energy Co. 4.5% preferred sported an investment-grade rating of Baa1 and yielded 4.29%. On the surface, it doesn't get much better than that these days for a quality security.

But, of course, there's a hitch: It's callable at any time, so if it were to be called, say, in a month, you'd incur a negative yield of more than 50% on your investment. If it were called in six months, the negative yield would be 5%. (You'll find a yield-to-call calculator here .)

No investment with a premium rate of return is without some risk, and with preferreds, it's mostly call risk. Certainly, there are other fundamentals to evaluate, primarily the quality of the issuer and the current yield, but I'm not going to buy a preferred that's too junky anyway, or one that has a low yield that's incommensurate to its risk.

Now, a word about quality: "Below investment grade" as to preferreds or bonds commonly indicates a rating below Baa3 from Moody's or BBB- from Standard & Poors. But a Ba1 or BB+ rating for a preferred might be attributable solely to its secondary place in the company's capital structure, rather than a reasonable reflection of the issuer's liquidity. Holders of preferred stock are subordinate to bondholders (though superior to common shareholders), so a given company's preferreds may, for example, be rated BB+ (non-investment grade) while its bonds are rated BBB (investment grade). In assessing preferreds, I generally give greater weight to the rating of the issuer's bonds.

With these reservations and complications, why do I bother to invest in preferreds? In the current low-rate environment, they provide returns of 4%-7% with relatively low price volatility. And the dividends for most of them are taxed at long-term capital-gains rates, rather than at the ordinary income rates at which bond interest is taxed.

Now, I wouldn't allocate more than 15%-20% of a fixed-income portfolio to preferreds, because they're subject to the vicissitudes of the overall market, and without a date-certain maturity you aren't promised a positive return on your investment. Those higher yields come with market risk and the earlier-described call risk.

Call risk can be mitigated (not eliminated) by diversification, which can be easily obtained by buying an exchange-traded fund, such as the iShares U.S. Preferred Stock ETF (PFF). Or to balance your preferreds against over-allocation to financials, you can buy the VanEck Vectors Preferred Securities Ex-Financials ETF (PFXF).

Here are several preferred issues that I've recently bought:

JPMorgan Chase /zigman2/quotes/205971034/composite JPM +1.06%  6.15% preferred, recently yielding 5.64%. It's rated BBB- by S&P. On the date I bought it in early August, the yield-to-call (Sept. 1, 2020) was 3.75%. In today's world, I'd take that consolation prize.

Morgan Stanley /zigman2/quotes/209104354/composite MS +1.73%  6.625% preferred, recently yielding 6.06%. It's rated BB, but the firm's bonds get ratings ranging from BBB- to BBB+. The yield to the call date (July 15, 2019) when I bought this stock was 3.29%, a quite acceptable three-year minimum return.

Citigroup /zigman2/quotes/207741460/composite C -0.36%  6.30% preferred, recently yielding 5.80% and rated BB+ (the bonds are rated BBB+). The yield to call (Feb. 12, 2021) was a healthy 4.23% when I bought this in mid-July.

As you can see, I like the preferreds of big financial concerns, but if the ratings and call-date considerations are favorable, I have no aversion to smaller banks, such as SunTrust Banks (which I also own), Valley National Bancorp or Cullen/Frost Bankers.

Still, the caution bears repeating: Preferreds that are past their call date can be rewarding investments, but they can result in losses if the yield-to-call is negative for any given future date. You can get burned. "Anytime" means any time, and a preferred that has a yield-to-call of 6% in 12 months might have a negative 10% yield if called in a month. Be careful, or opt for professional management by buying preferred stock ETFs.

Disclosure: Lewis owns preferred stock of JPM, MS, C and STI.

$ 127.14
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