It's not unusual for a preferred stock to trade in a narrow band. Some can go years without straying more than a few dollars above or below par value. Now, that doesn't mean these securities are immune to selloffs. Preferreds can be driven downward by rising interest rates. They can also be pressured at the corporate level by a weakening balance sheet or credit downgrade – anything that might threaten future dividends.
But in general, preferred shares are less jumpy than common shares. Plus, when harsh conditions necessitate a cut in common stock dividends, the preferred distributions usually continue without any interruption.
You'll notice I said "usually."
While rare, preferred dividends can sometimes be postponed in times of extreme financial distress. But even then, there is a silver lining. In many cases, the missing quarterly dividends must be paid and caught up at a later date when financial conditions improve. So if two payments were skipped in a bad year, preferred holders might be entitled to six the next.
This type of preferred is referred to as "cumulative."
With non-cumulative shares, missed payments don't necessarily accrue. But they may have another protective clause. If preferred share dividends are suspended for some reason, common share dividends must also be restricted until payments are first reinstated on the preferred.
Under this provision, if there isn't enough cash to pay both groups – the preferred holders go to the front of the line. Incidentally, the same is true with regard to any residual claim on assets in the event the business is liquidated. While preferred stocks are subordinate to bonds in the capital structure, they rank ahead of common stocks.
Finally, I should mention that some preferreds are convertible into common shares at some point in the future. And there's a whole sub-sector of unique preferreds whose coupon rates start out fixed for a few years and then switch to variable. These can be especially valuable during periods of rising rates.
As you can see, preferred stocks come in many different flavors. This is a massive $1.3 trillion global market.
There are dozens of low-cost exchange-traded funds (ETF) that provide broad exposure to this group. There are worse options than the iShares Preferred & Income Securities (NYSE: PFF).
But I prefer a hands-on approach. Aside from steering clear of potential trouble spots and utilizing leverage to enhance returns, closed-end funds (CEFs) have another structural advantage over ETFs: they fish in a much deeper pool.
Few people realize that preferred stocks trading on U.S. exchanges comprise only about 15% of this market. They are often referred to as the retail market. The other 85% of preferreds (some $1+ trillion outstanding) only change hands over the counter between institutional investors.
Since ETFs are limited to listed securities, they are shut out of the institutional side of the market. Keep in mind, OTC preferreds typically offer better call protection and higher payouts. And over the past quarter century, they have outperformed their retail siblings by 1.3% annually — potentially compounding into thousands of dollars more over the long haul.
That's why I give the nod in this space to Cohen & Steers Ltd Duration Preferred Income (NYSE: LDP).
C&S is a well-respected shop with $95 billion in assets under management spanning dozens of different strategies. As one of the early pioneers, it has decades of experience in the preferred stock world.
As you can tell from the name, LDP primarily sticks to shorter-duration securities with less rate sensitivity. Management prefers investment-grade issuers, which also helps to minimize risk. But with a current distribution rate of 7.5%, fundholders aren't sacrificing much in the way of yield.
Cohen & Steers is a bit unorthodox and unafraid to stray from the sector weightings and credit quality positioning of rigid benchmarks. I appreciate the flexibility to respond tactically to inflation, interest rates and other macro considerations.
More importantly, LDP has the freedom to invest where ETFs can't tread. And it takes full advantage. In fact, institutional OTC preferreds represent 93% of the portfolio, while exchange-traded securities take up just 7%. Like most closed-end funds, LDP utilizes leverage to sweeten returns and collect extra dividend income.
The portfolio provides exposure to more than 250 preferreds back by reputable issuers such as Bank of America (NYSE: BAC) and Goldman Sachs (NYSE: GS)
Compared to your plain vanilla ETF, LDP may seem pricey. But the five-star fund has earned every penny, chalking up top decile returns and outrunning 90% of its peer group over the past decade.
Pressing pause on the benefit fear train
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Whether that turns out to be true, or just another bit of "fake news," you owe it to yourself to check out a little known loophole my colleague Jim Pearce has discovered.
It allowed a small handful of regular Americans to collect over $115 million last year. You can join them by getting the full story here.
