Investors looking for compelling fixed-income investments are in a bit of a bind. Since the peak of the last bull market in early 2000, 10-year Treasury yields have declined from 6.5 to 4.6 percent as of late February 2006. All of this has been fine for capital appreciation. But the prospect for additional gains looks exhausted, and current income is just plain paltry.
The hunt for yields has caused compression in corporate bonds, producing pretty feeble spreads above Treasuries, which in late February were 79 basis points on A+ rate industrials and just 125 basis points on BBB-rated debt--the cusp of junk.
And with the yield curve flexing from flat to inverted, relief for longer-term investors doesn't appear to be on the horizon.
So, what to tell clients who are looking to achieve a meaningful portfolio balance, fund college tuition and retirement accounts, or trying to live off their principle?
Consider preferred stocks.
According to Steve Rubel, a Janney Montgomery Scott first vice president, who manages more than $100 million, "Preferred stocks generally offer better tax-equivalent yields compared to most bonds without taking on much additional risk. This helps to make them ideal for conservative accounts as well as for growth investors seeking ballast."
As illustration, Gregory Phelps and Mark Maloney, who co-manage $5 billion of John Hancock funds that focus on preferred shares, compare a Southern California Edison long-term senior secured bond to the company's traditional preferred shares. In late February, the preferred was yielding 38 basis points more than the 30-year bond--6.0 percent versus 5.62 percent. And because this qualified preferred dividend is taxed at a much lower rate than bond interest, the tax-equivalent yield difference exceeds 100 basis points.
Nuts and Bolts
For decades, corporations have issued preferred shares to diversify the way they fund long-term requirements.
There are many different types of preferreds--from DRDs that offer corporate investors a 70 percent tax break on dividends to dollar-based foreign issues, and debt that's wrapped in a preferred veneer [baby bonds, trust and repackaged preferreds]. Understanding these differences is essential for determining the right preferred investment for the proper account and exploiting inefficiencies that can evolve in this thinly traded market.
"Behaving much like bonds, preferred valuations and yields are affected by credit ratings, corporate and economic outlooks, the interest-rate cycle, tax status, and supply and demand." explains Kurt Reiman, who heads UBS' preferred research desk. "Their performance is more closely correlated with long-term debt than stocks, which is why analysts generally compare them to 30-year bonds."
Preferreds increase in value for four basic reasons: when the prospects of a troubled company improve and investors demand less yield; when overall corporate risk premiums decline; when long rates fall; or when there is a relevant change in tax laws.
While preferreds typically pay quarterly dividends, payment dates vary widely. To accurately compare current yields, dividends should be stripped away.
The higher yields reflect where traditional dividend-yielding preferreds lie in a company's overall capital structure--below debt but above common share dividends. Thus, in the event of financial troubles, shedding payment of common dividends comes before not paying preferred dividends. Still, the firm is not in default and can technically avoid bankruptcy for years as long as it meets debt and other statutory obligations. Of course, this scenario suggests fairly dire conditions and a company that should probably be avoided by sticking with corporations with consistently sound finances and credit ratings.
Accordingly, rating agencies typically rank preferreds two notches below senior unsecured debt, accounting for the essence of their attraction. Phil Jacoby, co-portfolio manager at Spectrum Asset Management, the subadvisor for several Nuveen Preferred Income funds, explains, "The best way to access higher yields is to trade down the capital structure of highlyrated companies rather than investing in higher paying senior securities of struggling firms."
But as the obscure nuances of the asset class begin to reveal themselves, there are other fundamental and market factors besides ratings that affect preferred yields.
Bonds mature; the many dividend-yielding preferreds called perpetuals do not. This means that issuers themselves do not repay principle. That's a matter of market pricing, which is normally driven by interest rates and credit quality. Accordingly, this added uncertainty may generate slightly higher yields.
Trust preferreds mature in sync with the long-term bonds that back them. However, because they pay interest which gets taxed at ordinary rates, their tax-equivalent yields are less than preferreds that pay qualified dividends, which are taxed at 15 percent. This may make the former more desirable for tax-sheltered accounts. However, this distinction may blur if the government decides not to extend this low tax rate, which is set to expire in 2008. If the market senses that extension is unlikely, expect prices of qualified- dividend preferreds to fall and yields to rise
Callable preferreds give the issuer the right, but not the obligation, to redeem shares at a preset "par" and are a common feature of most issues. Typically, an initial call date is five years after issuance, and is actionable on a monthly basis any time thereafter.
A corporation would typically call an issue when interest rates are falling, enabling it to refinance capital at a materially cheaper cost, or if they no longer need the capital. Over the past several years, many high-coupon preferreds issued at the beginning of the decade when rates were higher have been called. Those that have not tend to trade close to par as investors fear the sudden loss of capital. But that's not always the case.
With much lower refinancing rates available, it was an enigma why the Royal Bank of Scotland hadn't called its 11.2 percent preferred B series in August 2001, when it could do so at $25. Despite the risk of a call, some investors couldn't resist the juicy yields, and as late as 27 December 2003, the issue was trading at $27.35. The next day it was called and the price collapsed to $25, representing a loss of 8.6 percent for investors who got into these shares late.
According to Janney Montgomery's Rubel, investors should always consider the worst-case scenario when assessing risk. "A simple rule," he explains "is to buy preferreds at or below a call price with at least two years of protection before the call date to protect against capital loss and ensure the flow of at least several years of income."
Occasionally, a preferred may offer a slightly above-market yield several years from call, and trading above par. To determine whether it will produce an acceptable return, Rubel advises checking the yield-to-call [total income minus potential capital loss if called, calculated on an annualized basis]. The risk of a slight loss in principle may be worth exposure to higher yields, especially if you think long rates will rise and the chance of a call is minimal.
Another distinction between preferreds involves payment of missed dividends. Cumulative issues agree to pay investors all missed dividends before reinstating dividends on common shares while non-cumulative issues are not required to make up missed payments. In theory, this makes the latter worth less, requiring higher yields. Last year, MetLife's $2 billion preferred issue came out with an attractive 6.5 percent coupon in part because it was non-cumulative and had non-discretionary earnings- related triggers for suspending dividend payments.
While the yield advantages are less pronounced than they were several years ago, many foreign preferreds continue to offer yields superior to equivalently-rated domestic securities. The reason, according to Dan Campbell, a consultant and former head of hybrid capital securities at Merrill Lynch and Deutsche Bank, "is the misperception that there's higher risk in buying foreign securities." So not only can investors realize greater returns from quality bank preferreds issued by the likes of ABN-Amro and HSBC, they benefit further from the low dividend tax rate as well. And unlike common share ADRs, these preferreds have no direct currency risk since they are dollar-denominated, trade exclusively in the U.S., and don't track home-market shares.
For qualified high-net-worth investors, another corner of the market worth peering into is the world of unregistered securities-- 144[a]s--which are typically issued at $1,000 par value. Because these are private placements that don't trade on exchanges and need not file anywhere near the amount of disclosure required by publicly traded preferreds, they usually pay higher coupons. Still, they are agency-rated, and many are quality issues that likely have an extensive public data record from previous public offerings.
In the past, liquidity for these issues was typically thin, which can produce inefficient pricing.
More recently issued 144[a]s are more actively traded--for example, Washington Mutual's 7.25 percent issue, which came out in March. This BBB-rated preferred was trading slightly above par, paying a current yield of 7.20 percent. But this perpetual, non-cumulative issue is taxed as ordinary income.
If the task of trawling for preferreds seems daunting, advisors can turn to preferred stock mutual funds which relinquish some individual issue transparency in exchange for professional management to navigate the vagaries of this asset class. However, the dozen or so such funds out there require a deeper understanding than typical mutual funds because they are closed-end.
The obvious advantage of preferred mutual funds is that they structure a balanced basket of different grades, yields, call dates, and maturities that pay monthly dividends, relieving you of constant monitoring, especially when rates change or issues get called.
But the chief benefit of a closed-end fund is its ability to leverage up to a third of its assets. That means that if an IPO raises $100 million, the fund can borrow an additional $50 million at short-term rates--adjusting between every 7 and 49 days--to boost yields.
For example, take the John Hancock Patriot Preferred Fund-a portfolio with an average rating of BBB+--whose leveraged market yield in late February was 6.37 percent." Comprised primarily of qualified dividend issues, the fund's fully taxable equivalent yield was 7.49 percent-mpressive when compared with an A-rated 30- yield corporate that paid 5.61 percent. Fund co-manager Gregory Phelps explains that, historically, 30 to 60 basis points of this advantage are attributable to preferred's lower capital placement and roughly 125 to 150 are due to leverage.
Over the past three and five years through the end of February, the fund's annualized returns were 9.46 percent and 7.95 percent, respectively. According to Morningstar, the average long-term bond fund generated 5.38 percent and 6.49 percent returns over the same periods.
The main risk of closed-end funds is that shares rarely trade at their underlying value. Because a closed-end fund trades like a stock exposed to the forces of market demand, actual trading value will vary from its underlying net asset value. When a spate of preferred funds came to market in 2002 and 2003, demand was strong, producing a premium over NAV. But as interest rates began moving up and investors feared underlying valuations would correspondingly decline, the premium turned into a discount.
This concern was compounded as the yield curve moved toward inversion during the fourth quarter of 2005. Investors feared the potential backlash of leverage as short-term rates exceeded long-term rates. As a result, discounts hit close to 15 percent for many funds.
But since the beginning of the year, as the market anticipates the end of rate increases and the fear of leverage has diminished, sentiment has improved.
Because funds borrow money by issuing their own preferred DRD-eligible securities, the yield curve would have to stay deeply inverted for quite some time before leverage would actually backfire. On January 23, 2006, Phelps was still able to borrow at just 3.46 percent, several hundred basis points below what his investments earn. And some funds gain further protection by hedging their interest- rate exposure. However, if long rates rise, pushing down the price of preferreds, leverage will accelerate a fund's descent.
But to Janney Montgomery Scott's Rubel, this may be an opportune time to consider moving into preferreds. "If interest rates are topping out, then investors may be able to lock into yields near their peak while reducing the risk of capital loss due to further rate increases," he says.
Even if Rubel's timing proves off for the long term, quality preferreds have consistently proved their worth as an effective means for generating yield during all phases of the interest-rate cycle.
Eric Uhifelder (Uhlfedler@hotmail.com) has covered domestic and international capital markets over the past 13 years for various brokerages and publications