Income investing: potential perils and benefits of preferred stocks

2015 was a tough year for investors who were seeking both growth and income from their portfolio. While income might have been delivered, growth was tough to find. Income-producing asset class yields 1-yr returns Sources: Morningstar, Factset, S&P.
Preferred stocks represented by S&P Preferred Stock TR Index; U.S. equity represented by S&P 500® Index; U.S. Bonds represented by Barclays U.S. Aggregate Bond Index; REITs (Real Estate Investment Trusts) represented by FTSE EPRA/NAREIT Developed Index; High yield represented by Barclays Global High Yield Index; Utilities represented by S&P Utilities Index; International equity represented by MSCI ACWI Ex-USA Index; Infrastructure represented by S&P Global Infrastructure Index; MLPs represented by Alerian MLP Indexes. That’s challenging in the long run because it is the growth element of the portfolio that allows the income to be sustainable over time. Recall, Total return = Income + Growth (i.e., capital appreciation)

Balancing growth and income

For example, an investor with a $100k portfolio that earned 3% in income but lost -8% in capital “appreciation” over a year would have experienced a total return loss of -5%. The portfolio began the year with $100k and ended with a value of $95k. What’s that hypothetical income-seeking investor to do? Basically the investor has two options:
  1. hold constant the percentage drawn from the portfolio
  2. hold constant the dollar value drawn from the portfolio
But, both options eventually degrade the value to the investor in different ways. Option #1, a constant percentage, erodes the current income available. After all, if the investor continues to draw 3% from the portfolio, they are drawing from a lower base, which will yield a smaller dollar amount ($2.85k vs. $3k). Option #2, a constant dollar value, erodes the portfolio principal, which in turn decreases the ability to generate future income. In other words, if the investor wants or needs $3k (like the previous year), they will be pulling a higher percent off the portfolio (3.2% vs. 3%). So, balancing growth and income is critical in the quest for sustainability.

Preferred stocks: the positive outlier in 2015

The obvious income-producing outlier in 2015 was preferred stocks, as shown in the chart above. They delivered on the income and the growth side of the equation. But before being tempted to allocate a portion of a client’s portfolio to preferreds, let’s do a quick review.

What are preferreds?

Preferred stocks can be a nice complement to an income portfolio as they are a hybrid security with elements of both stocks and bonds. While they are listed as an equity, income investors like them because they typically pay a dividend. Often, those dividends are fixed – or known – producing a higher, more stable income stream for investors over common stock. They are also higher up in the capital structure than common shares but lower than bonds in case of liquidation. On the surface, these benefits seem like a great answer to the income-seeking investor’s challenges. But, as with any investment, there are two sides to the coin and savvy investors should be aware of the risks of investing in preferred stocks – particularly right now.

Buyer beware

First, companies can defer or skip dividend payments. Depending on the type of preferred stock (e.g. callable, convertible, cumulative, non-cumulative, floating coupon, fixed coupon, trust, and variable coupon) companies can choose to not pay/defer a dividend without the risk of default. This flexibility is one of the reasons companies prefer issuing preferreds. But, it should give income-seeking investors pause and evaluate if the risk of deferred or non-existent dividend payments threatens their income priority. Second, sector concentration. As of 12/31/15, the Financials sector made up 84.1% of the S&P Preferred Stock Index. Right now, investing in preferreds basically means investing in financials. Investors need to decide whether they are comfortable with that level of concentration in one sector right now. S&P U.S. Preferred Index Sector Breakdown

The bottom line

Preferred stocks can be a nice complement to an income portfolio but it is important to understand the benefits and potential pitfalls before investing. We believe balancing various sources of income is best, particularly in the current market environment.