Top Preferred High-Returning Yield Picks: Anatomy of Preferred Stocks for Income Investors

Author: Kip Lytel, CFA

Steady stream of higher-yielding income

Having a predictable coupon payment stream of high market yields is not only attractive but also very desirable to both retirees and income-oriented investors. Equally important to these yield-seeking investors is the frequency of dividend payments.

Fortunately, preferred shares deliver on both counts with dividends distributed generally on a quarterly basis, and sometimes even monthly, along with high yielding payouts. While you’ll be hard-pressed to find a dividend aristocrat stock with a yield above 5%, individual preferred shares typically offer compelling yields in the richer 5%-7% range. In the simplest terms, a 5% yield on a $25 preferred stock means that the preferred stockholder will receive $1.25 per year of income on each share owned.

Since the understanding of the individual preferred share markets are considerably opaquer to most individual retail investors than buying preferred funds, the purchase of individual issues is often overlooked. However, instead of buying preferred ETFs and mutual funds where investors don’t have the luxury of screening for higher-yielding opportunities, or avoiding fund fees, toxic sectors, and lower credit-rated issues, retail investors should consider accumulating a diverse portfolio of select preferred company shares. 

Retail investors can purchase preferred shares just as they would any stock; however, there are liquidity and availability constraints. For instance, at times investors need to check the availability of the higher demand preferred stocks for a few days before inventory becomes available for purchase. If there is availability, then investors would then just place a market order for the preferred stock in a brokerage account for trade execution.

Top Preferred Picks

First, Moody’s, S&P 500, Fitch & Dun Bradstreet provide credit ratings on companies that may, or may not, include ratings on preferred shares. That said, nearly 90% of the senior debt of preferred issuers does have a credit rating of investment grade. 

Our selection of top preferred shares strikes a balance between the financial health of the corporate issuer and the coupon offered, taking into account the corporate rating (or senior debt) and any relevant Wall Street analyst reports.  Other risk mitigation considerations are sector diversity, liquidity, history of preferred dividend payments, and interest coverage ratios. Finally, within the scope of a rising rate environment, the superior choices would be higher-yielding series of issues to help protect the investment from the inverse price correlation with increasing interest rates. 

Anatomy of Preferred Stocks

Much like common stocks, preferred shares are issued by corporations to the public by the means of a formal securities offering where the issuing company receives the funds. Preferred shares are also actively traded on the open exchange market - the most common of which is the NYSE – with a moderate bid/ask spread, but again, with far less liquidity than common stocks. 

However, unlike common shares, the preferred class waives two essentially participation rights:  the rights of governance (via voting) and often the right to participate in any common stock appreciation of the underlying issuance company. Thus, unless the preferred shares are “participating” or “convertible,” investors forgo the common stock appreciation in return for preferred rights in the form of higher yield compensation. 

Preferred stocks typically have a higher rate of return than fixed-income securities because they are often riskier than investment-grade conventional bonds; they often don’t have a maturity date, and payments can be deferred.

The number of preferred share issuances catapulted back in 1996 when the Federal Reserve permitted U.S. bank holding companies to treat certain types of preferred stocks as “Tier 1 capital,” which is a key measure of a bank's financial strength for capital adequacy purposes. The “preferred” class of stock shares ranks above common stock shares with a priority claim on dividend distributions or assets distributed to shareholders. In other words, payments on preferred securities must come before payments to common stock - hence the name preferred. 

Preferred stocks are either “perpetual” with no maturity or are generally long-term in nature, typically with long maturities of 30-to-50 years. However, many preferred issues with a stated maturity of 30 years include an issuer option to extend for an additional 19 years. Finally, most preferred stocks have an optional redemption period in which the shares may be redeemed, at the issuer’s option, generally after five years of issuance.

Much like many bonds, preferred stocks generally can be called at the original par value set by the issuing company. Yet, this could be a double-edged sword for investors since they may lose higher than market coupon payments, while they may also incur a loss if the security was purchased above par.

Insofar as there are hundreds of preferred share issues, the bulk of preferred companies stem from financial industries like banks and insurance companies, with issuance at $25 par values. However, par can vary higher or lower, with a large swath of preferred shares at $1,000 par value. Nonetheless, the corporate issuers sector exposure remains diverse with financial banks, financial entities, insurance companies, energy companies, REITs, utilities, and telecommunications industries.

Types of preferred shares:

• Cumulative: You may retain the right to suspend payment of dividends. If preferred stock is designated as cumulative, the suspended dividends accumulate, and the issuer is obligated to later pay them in full.

• Non-Cumulative: Means that if payments are deferred, these dividends don't accumulate and typically won't be paid back later. This is a less attractive feature and often warrants higher yields for investors.

• Trust Preferred: Issued by a trust set up by the issuer and funded by the debt securities of the issuer. Like any other bonds, trust preferred shares usually have stronger protections on interest payments over traditional preferred stocks (thus rank higher).

• Participating: A participating feature gives preferred shareholders the right to receive a share of dividends paid to common shareholders. This is in addition to preferred dividends.

• Convertible: Convertible preferred shares may be exchanged for common shares, and as such, they can have greater potential for upside appreciation.

After the 2008 global financial crisis, the major credit rating agencies revised their preferred security rating methodologies, and consequently, preferred ratings were lowered by several notches; pre-global financial crisis, the average rating was around A-. Those new to preferred shares might be surprised to learn that during this capital market upheaval preferred share index lost greater value than stocks.  This is somewhat misleading, however, since the universe of preferreds has about an 80% concentration in financial services, which includes banks, insurance companies, brokerage,e and private equity issuers.[1] A financial advisor in Santa Barbara would likely emphasize that this historical financial crisis loss data point has also elevated the standard deviation risk measurement for preferred shares relative to common stocks. 

Additional Risk Considerations & Disclosures

First, admittedly, this “Top Pick” list is not all-inclusive, as there are many other preferred shares in the marketplace that could have easily made this list.  Simply put, a copious inventory of all top-tier preferreds on a risk-adjusted basis was not the sole goal of this article. 

It is always wise to check company credit ratings, evaluate stock performance (if public), and read analyst reports. Only buy issues that have credit profiles that make sense for your own portfolio. Like bonds, preferred shares generally carry a credit rating from a recognized rating agency. Generally, preferred stocks are rated about three notches below bonds, and this lower rating reflects the higher risk in the form of having a lower claim on the assets of the company. Preferred stocks payment obligations can also be deferred during periods of economic corporate hardship, where on the other hand, bond interest payments represent a contractual obligation.

In other words, investors should not just buy a preferred stock, coupon clip over time, and no longer revisit the investment catalyst. Case in point is in the event the issuing company undergoes restructuring, then preferred shares would be lower on the capital structure in terms of claim, therefore would be paid after the bondholder's higher priority claims. For example, Southern California Edison (“SCE”) was purchased as a portfolio holding for some of our clients, but after the Montecito, California, fires and subsequent mudslides, several billion-dollar class action lawsuits ensued over allegations that SCE was the negligent cause of these disasters. This liability risk was not present when the SCE preferred shares were initially purchased, but after this new negative development, we sold the preferred at a moderate loss.  Furthermore, these preferred shares still trade at elevated prices that don’t reflect this material liability risk, and the likely conclusion is that many retail investors are not monitoring these new heightened risk considerations.

In closing, while preferred shares provide an attractive source of relatively high and stable income, it’s important that investors understand the associated risks.  Let’s recap these risks: credit, liquidity, duration (since preferred shares often have no maturity date, given most perpetual), and issuers can defer dividends during periods of financial distress. A good reference point for risk is the fact that preferred shares were one of the hardest-hit investments during the 2008 credit crisis due to the high concentration in banks, financials, and real estate. Therefore, investors should be selective, undertake due diligence, and seek sector diversity.