Investors Starting to Eye Preferred Stocks More

Preferred Stocks

With the growth of the stock market in general thought to be dimming, and bond yields being so low, preferred stock is starting to look more attractive to many investors.

One of the first things you learn when you study stocks is that there are two main types, common stock and preferred stock. Preferred stock has a nicer sounding name, but the preferred part means that these shares are given priority in certain circumstances, like when a company goes under, where preferred shareholders have first dibs on whatever may remain after their debts are paid, including fully paying off bond debt.

Given that a company goes officially under when it can no longer pay its bondholders, usually involve just missing interest payments, if they had money left over after all bondholders are paid, there wouldn’t be any need to default in the first place. It therefore does not bode well for either preferred or common shareholders when this happens, and the extra security that preferred shareholders may believe that they have is pretty much just an illusion.

The other meaning of preferred with preferred shares is that they have first dibs on dividend payments, and while companies may reduce or eliminate any dividends that they pay on common stock, it’s a lot harder to do that with preferred shares as they function more like bonds, with set payments due with companies having limited flexibility in sidestepping them or even postponing them.

This feature may excite those we call income investors, especially those who have been disappointed at all the dividend slashing that has been going on with common stocks these days, but before we get too excited about this, we need to look beyond the interest payments and look at the whole picture, total returns, the exact same way we need to do with bonds but something most people just ignore.

A lot of investors even try to avoid reckoning with common stocks, as if the dividends are the only thing that matters at all, and they then base their investment decisions on this alone. Common stocks, including higher dividend stocks, preferred shares, corporate bonds, municipal bonds, and even treasuries are all subject to changes in price valuation completely independent of any interest they may pay, and neglecting this a terrible mistake where we blind ourselves out of ignorance.

Of the various asset types, common stock is the most prone to these price changes, called volatility, although some stocks are a lot more volatile than others. Preferred shares are less volatile generally, with bonds being the least volatile.

We can have a peek at the iShares 20+ Treasury ETF to see how even treasuries, considered to be the least volatile of all investments, are prone to a lot of price risk by looking at how this fund moves. Since October of 2018, the value of the fund has risen by 45%, which includes both price movement and interest collected.

Needless to say, this has not moved up because these investments have paid such incredibly high yields, and you don’t get to a fund’s shares gaining $50 in a year and a half from the paltry amount of interest they pay. That only accounted for about $4, with the other $46 being from people bidding the price of this up like we see when stocks rise.

We ended up hitting the ceiling with these bonds, where we got to the point where people did not wish to pay more no matter how terrible the economy has gotten, but these things can definitely lose value as we move back toward historic levels. If we move back to where we were a year and 8 months ago, our tiny interest payments may once again get overwhelmed by the price action, as we would lose over a third of our money on a net basis, the net loss, which is what determines how much the value of these investments actually are.

Given that we need to worry about this risk with bonds so much, we should not be surprised that we also need to pay close attention to preferred stock in the same way. While preferred stocks do not move as much as common stocks do, they still move quite a bit, and they can still bite, and bite very hard at times.

There just isn’t a kind way to describe people just looking at the interest payments alone when investing in these things, especially given how obvious this should all be, especially if you are investing in bond or preferred share funds like the great majority of people do. You just need to look at the chart of these things and see the value of your investments move, but the funny thing is, so many don’t even tend to pay attention to even this.

They might see the value of their portfolio decline and simply have no idea why, or not even enough interest to even wonder. Such an approach is incredibly bad and if investors simply come to the realization of how these investments actually work, that would at least be able to see what is going on. This really isn’t talked about much at all by either the financial industry or the financial media, and this is truly a case of the blind leading the blind for the most part.

Once we become enlightened enough to know that the price of these things do move and we dare to peek at charts, like for instance the benchmark iShares Preferred and Income Securities ETF, this will also help us get over whatever illusions that we have that price risk isn’t a big deal with preferred shares.

For example, from the period between March 2007 when this fund was first rolled out until March 2009, this fund lost a whopping 72%, and took an even bigger hit than common stocks did. This is after the dividends that people earned got factored in. These are far from low-risk investments, and this fund actually has a beta of 0.95 over the last 3 years, pretty close to the S&P 500 but without the much greater upside that the S&P 500 has.

During the 2020 crash, preferred stocks didn’t fall quite as hard as common stocks did, with a drawdown of 28%, but this isn’t a whole lot less. The risk here is people thinking that these are much tamer investments than common stocks or even completely tame if don’t bother to check at all, but this is far from the case.

When an investment moves down almost as much but only grows by a small percentage of the other investment, we’d be fools to ever want the bad side of this deal, although if we just keep our eyes on the dividends and not on the changing values of our investments, we can become fooled.

This is Not Only a Bad Investment, It’s Becoming a Worse One Over Time

Something not so obvious on a chart is how preferred shares have fallen so much out of favor, more and more each year. Looking at how the average annualized returns of this fund has declined shows this pretty clearly though.

When we consider that the 10-year average return with this fund is 5.8%, the 5-year average is 3.24%, the 3-year comes in at 2.11%, with the 1-year return sitting at 1.54% and the 3-month at –1.72, this a very disturbing trend at work here. While the results from this year are understandable, we surely have not been in such a downtrend of the sort for this long to produce results like this, and quite the contrary actually. This can only mean that preferred stock is falling more and more out of favor with each passing year.

Preferred stock, like all stock, is subject to the forces of supply and demand in the stock market, where the more a stock is in demand, the better it will perform price-wise. This data is indicative of a trend away from this sort of stock, although whether or not this is actually happening doesn’t even matter given how terrible the risk/reward ratio is.

As people pull more money out of these shares, and as the supply increases from this as the demand increases, this movement directly drives the value of these investments down. We may want to pat ourselves on the back for earning good dividends, as this puts a little in one pocket but takes even more out of the other. If you are pickpocketed like this and don’t even care to check that pocket, you are not being guided by reason.

The risk/reward ratio with preferred stocks right now is nowhere near as bad as it is with bonds, and given that this is where the income investors really congregate, this at least bears mentioning. Treasuries have done fabulously lately but the sky is not the limit like it is with stocks, and the yields dropping to almost nothing is where the ceiling actually is. Given that we are up against this ceiling now, the risk simply overwhelms the potential rewards, where they really have nowhere to go but down from here and this will involve bondholders taking big losses as this unfolds.

With the potential return virtually zero and the risk being so exceedingly high, this is why we have been telling you for quite a while now to beware. It’s not even easy to dream up a worse investment, and as much as stocks have been hammered, they have come back pretty quickly. There’s no telling how many years it will take to get bond prices back to the ones that shattered the all-time records, and this may actually never happen in our lifetimes.

If you buy something that can really only go down and pay prices that we may never even see again, this is as good of a prescription for losing money on an investment as there is. Preferred shares are certainly preferable to this, but whether they are preferable enough alongside other options is what we need to figure out before we leap.

All of those returns from this fund get beaten very badly by the average total return that stocks have provided over this time, higher dividends or not. It should strike us as very odd that we would be giddy about dividend payments which in themselves aren’t competitive to the total returns of stocks, without bothering to actually check and see what your total returns of your preferred stock may be, coming in significantly lower than these dividend payments.

If we could go back in time to 2007 when the fund was born, we could have bought shares for about $50 per share. They are trading under $40 now, all these years later. That’s 13 years to spread out this 20% capital loss, and while your dividends would have exceeded this, you just didn’t earn this dividend income, you got that less the capital losses, which is why your total return can be lower than your dividend rate.

The Nasdaq 100 common stock index is up 229% since this preferred stock fund debuted, and that includes the crash of 2008. Common stocks just don’t beat preferred stocks in terms of total return, they completely shame them. This includes all the ups and downs that income investors fear with stocks, including the one this year.

Preferred Shares Only Make Sense if You Are Confused

Preferred shares take almost as big of a hit price-wise but take a lot longer to recover, if they ever even do, as we’re still off the March 2007 price with this fund by 20% and these stocks experienced zero price growth over the last 10 years, while the stock market exploded.

They call a baseball catcher’s equipment the tools of ignorance, but using income investments blindly is truly out of ignorance. As hard as we may try, we cannot even conceive of a situation where owning preferred shares would be a sensible choice, or even one where it would be anything but regrettable.

We might think that a bear market in stocks might be a good time, and these are certainly times where you do not want to be in common stocks and take the bashing from the bear, but preferred stocks get bashed as well and almost as much. We do not want to be making the grim mistake of thinking that losing less but still losing is ever desirable, and as foolish as this seems, there are plenty of investors that make this unfortunate mistake.

Your extra helping of dividends that preferred stock offers isn’t going to help you against a bear, who will grab that as an appetizer and then attack you. When you’ve lost the close to 20% that preferred shares lose when a 20% or bigger bear hits common stocksr, your piddling couple of percent extra over a whole year just isn’t going to make much difference and will still have you injured and lying on the ground next to your common share friends.

Even though bonds are so-called income investments as well, even though a good portion of their net results depends on price, bonds certainly have their place and time, when they are achieving returns that eclipse that of stocks for a while. You never see that with preferred stocks though, as they may outperform by a bit overall at certain times but will never do this with a positive return.

Comparing returns does involve a certain conception of risk, the risk of lost opportunity. When you consider how great this particular risk is compared to common stocks, this should scare the daylights out of investors. This is not an advanced concept, but it surely must be to those who don’t even bother watching the true value of their investments move.

The dividends over these last 13 years, less the 20% that you lost, involves a loss of almost 200% compared to just buying shares in the Nasdaq instead at the time. It is only when we understand this as a real loss that we may then become an awake investor.

It’s too much to hope that very many of these folks will awaken enough to see how inferior preferred shares actually are overall, and this isn’t a bedtime story that the investment industry wants to tell even if they actually do know the story, and sadly, it doesn’t seem like many of them have much of an idea of any of this and are napping right alongside investors on this one.

While we sleep, we end up having some weird dreams and become scared of much more sensible approaches, for reasons that aren’t really explained well, but at the same time, we don’t really question things as we dream. If our investment fates matter to us, we must fight through all the deception out there provided by an industry whose business it is to sell us these investments, and achieve the will to think for ourselves more.

We don’t just need to think twice about preferred shares, we need to think about them for the first time, as not thinking at all the first time around does not count.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.