Avoid Preferred Stock

A major money center bank recently updated its website in such a way that before customers (and non customers) even log in they are encouraged to “Consider Preferred”.

Site users are immediately directed to a linked article that outlines the main benefits of bank-issued preferred stock (there are other companies that issued preferred, but the article focuses on bank-issued preferred). The main benefit is that yields are higher than bonds issued by the same institution (the article partially attributes this to supply and demand imbalances from a refinancing cycle and partially attributes this to the fact that they sit lower in the capital structure) so that they now yield as high as 5% whereas the 10-Year Treasury yields 2.90%. An additional benefit is tax treatment that is favored over that of bonds (preferred pay “qualified dividends”).

The article then goes into the risks. One risk is that the preferreds sit lower in the capital structure than bonds and have a lesser stake in liquidation. A second risk is that the dividend on a preferred stock is paid at the issuer’s discretion and can be turned off if the issuer first eliminates its common dividend. (It is easy to discount these two risks as insignificant as banks are significantly more secure than in 2008).

Yet another risk is that call provisions could cause the yield-to-call to be significantly lower than the yield, which the article correctly cites as a serious risk for any instrument that is being purchased at a premium over its face value.

Finally, the article mentions interest rate risk. It states:

The perpetual nature of a preferred also brings interest rate risk, as there is no set maturity date in which the issuer must redeem the security. If longer term interest rates go higher, the price of the security may dip.

We think that this is the single biggest reason to avoid preferreds, and we don’t think that the risk can be well mitigated by buying fixed to floating rate preferred stock, as the article suggest.

Interest rates are going up. We have stated that bond prices can get killed in a rising interest rate environment. While BestCashCow is the most comprehensive source of CD rate information, we’ve also encouraged investors to consider carefully the implications of investing in long term CDs given the backdrop of short-term rates that are likely to move higher over the coming 12 months.

Preferred stocks, unlike bonds and long-term CDs, have no maturity date. While these instruments can come under severe pressure in a rising rate environment, bond investors and CD investors always have the option of holding an instrument to maturity in order to receive their full principal (provided the issuer stays solvent).

As we move from an interest rate environment that has been lower than anyone alive has ever seen for longer than anyone imaged, it becomes entirely possible that we may never go back. The Fed itself is guiding towards a Fed Funds rate of 3.375% at the end of 2020. If short-term rates go there and stay there, long-term rates will presumably go higher, maybe much higher. The value of instruments that represent a perpetual claim on an issuer’s assets without any date of redemption will fall, fall continuously, have no floor, and never recover.

It is very tempting to reach for yield here, but we think that prudence is especially warranted in a rising yield environment. Savings rates are already pushing 2%, and, if you must reach, the premium offered by one-year CDs is higher than it has been in a decade. See one-year CD rates here.