Posted by on Aug 15, 2016 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig |  Aug. 12, 2016 12:44 pm ET

In investing as in life, popularity has its price.

Investors in preferred stocks may learn that lesson before long. With stocks hitting record highs in lockstep this week and bonds providing income you can’t find without a microscope, preferred stocks have been one of the trendiest investments around. But this market shows some signs of overheating.

Preferred securities, which are an amalgam of stocks and bonds, offer the stream of regular income that investors crave. The S&P U.S. Preferred Stock Index yields more than 5% — putting common stocks (at a 2% yield), high-dividend stocks (3.1%), corporate bonds (3%) and even “emerging-market” bonds from developing countries (4.3%) to shame.

A kind of buying panic has broken out. The iShares U.S. Preferred Stock exchange-traded fund, which seeks to track the market, has taken in $2.2 billion in new money so far this year. Historically, the price of preferred stocks almost never rises, with virtually all their return coming from the fixed dividend rates they offer; this year, however, nearly half the 7% total return of the S&P preferred index has come from climbing prices.

To see why overheating could be a risk, it helps to understand more about how preferred stocks work.

If a company goes into bankruptcy, preferred shareholders have a higher claim on any remaining assets than the common shareholders do.

But preferred investors also have a lower claim on a company’s assets than bondholders do, and there’s no guarantee that a company won’t skip a dividend. Preferred investors, unlike holders of common stock, don’t participate on the upside if a company grows more profitable.

So preferred stocks tend to offer returns similar to those of bonds, at a level of risk that can approximate that of stocks.

Over the five years ended July 31, the S&P U.S. Preferred Stock Index returned an average of 7.8% annually, beating the 3.5% return of the overall bond market.

But look back, and the risks loom larger: Preferred stocks lost 12.2% in 2007 and another 25.8% in 2008, including 32% in the third quarter of 2008 alone. Even in the third quarter of 2011, well after the financial crisis had eased, preferred stocks lost 7.6%.

That’s partly because preferred investors aren’t just buying yield; they are making a highly concentrated bet on a single sector of the economy. Four-fifths of all preferred securities are issued by banks and other financial companies.

And as interest rates fall and investors chase yield ever more desperately, some preferred stocks are disappearing — and handing losses to Johnny-come-lately investors.

Almost 28% of the iShares fund’s $17.5 billion in holdings are callable by the end of this year, says Dorothy Lariviere, an analyst and product consultant at the firm.

That means the issuers have the right — although not the obligation — to redeem those securities, taking them off the market in order to refinance at today’s lower rates. If you paid around par, or redemption, value — typically $25 — you’ll get all your money back. If you paid much more than par value, you’ll lose money.

Since the beginning of June, a total of 23 issues valued at $9.6 billion have been called, says Jason Giordano, a fixed-income analyst at S&P Dow Jones Indices.

Ms. Lariviere says iShares is confident that the fund will be able to replace any preferred holdings that get called; companies have issued approximately $30 billion in new supply so far this year.

Normally the market anticipates that an issue will be called and gradually adjusts its price downward. But so much money has rushed in that prices have gotten out of whack. Some preferred issues are trading at premiums that may hand investors sudden losses.

Consider the $950 million in preferred securities from Bank of America’s Merrill Lynch Capital Trust II, whose price shot up from $25.05 in February to $26.50 in June, far above the $25 par value. Then, in July, the bank announced it would call the securities on Aug. 15. Their price fell 2% in a day.

There’s another concern. At the end of last year, the iShares fund held more than 10% of the total outstanding value of 37 of its holdings. As of Aug. 10, according to FactSet, the fund owns more than 10% of the outstanding value of 185 of its holdings. (It has a total of 293 positions.) That’s a lot of any market for a single fund to control in such a hurry.

“We consistently monitor capacity within the underlying market for the securities,” says Ms. Lariviere. But there aren’t a lot of steps an ETF can take to prevent itself from growing too big too fast; unlike traditional mutual funds, it typically isn’t feasible for ETFs to close to new investors or impose redemption fees that could discourage short-term buyers.

Investors might consider curbing their enthusiasm before this hot market delivers a scalding.

Source: The Wall Street Journal,