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Is It a Good Time to Buy Preferred Stocks?

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Mitchell Stapley, CFA, has an interesting theme for yield-seeking investors: preferred stocks, an intriguing and counterintuitive recommendation, given the environment of rising interest rates.

Stapley, who manages the Touchstone Flexible Income Fund (MXIIX), has roughly 40% of its assets in preferreds.

(The fund has about $294 million of assets and has earned a four-star rating from Morningstar on its institutional shares.)

As expected, recent rate increases have created headwinds for preferreds.

The S&P U.S. Preferred Stock Index produced a -5.69% price return year to date through Sept. 6; the total return was -1.49% for the same period.

Through Aug. 31, MXIIX had a total return of -1.66% for its institutional shares. (The S&P Preferred Index is not an exact benchmark for the fund because the fund holds other fixed-income investments.)

What’s Stapley’s rationale for buying preferreds?

He cites several factors. The first is that his firm believes we’ve already experienced most of the expected interest rate increase.

Historically, he says, 10-year rates have a tendency to migrate toward the level of nominal GDP growth. Rates can move temporarily above and below that level but eventually trend back to it.

“As we get towards 3.25%, and given the fact that we’ve come off of the 1.42% low, we’ve done more than two-thirds of the work,” he says. “That’s kind of our central tendency for rates right now, somewhere around 3.25%, give or take, plus or minus. But it’s not 4%, it’s not 5%, and the only way we get to that 4% or that 5% is if we would get some kind of real sharp uptick in economic activity.”

If you see that development, Stapley requests, let him know. “That’s not in my crystal ball or too any prognosticators’ out there,” he admits.

Preferreds’ yield advantage over straight debt securities is another attractive feature, according to the fund manager. He cites cumulative securities issued by JP Morgan (JPM) as examples.

The yield on the bank’s straight five-year debt has been topping out around 2%, he says. In contrast, he can buy the bank’s cumulative preferreds with a $25 par value and earn over a 5% yield.

That raises the obvious issue: There must be a risk tradeoff to earn the higher yield, right?

“With that cumulative preferred, if JP Morgan suspends the dividend on their equity, they also suspend the dividend on that preferred,” Stapley explains. “That’s my risk. My risk as an investor is that Jamie Dimon will decide that he had to suspend his dividend payment on his common.”

But, he adds, the likelihood of a dividend suspension on the common shares triggering a dividend suspension on the preferreds “is pretty low.”

This means “we’re willing to take that 300 (basis points) plus yield advantage to own the preferred versus owning the debt,” explains Stapley.

The final factor he cites is the market structure for preferreds.

Preferreds can range from securities that are basically senior bonds in the issuer’s capital structure to non-cumulative issues that behave more like equity. That complexity, combined with a relatively illiquid market in comparison to Treasurys or large-cap stocks, creates inefficiencies and opportunities, he maintains.

“We’re very seasoned portfolio managers in terms of the preferred market or the convert [convertibles] market,” says Stapley. “We know the names, we know the issuers, [and] we know how they lay out in terms of deal structure. We can go in there and look for those mispriced opportunities because you don’t have a lot of people following it.”

Research by senior closed-end fund analyst Cara Esser at Morningstar confirms Stapley’s contention that active management can benefit investors in preferreds.

(Most actively managed funds that invest in preferreds use do so via closed-end funds (CEFs), experts say.)

In an article published earlier this year,  Esser noted: “There’s some evidence suggesting actively managed preferred-share funds have had an edge over their passively managed [preferred-share-fund] rivals …  [E]very single CEF and mutual fund outperformed every single ETF and both indexes over the last year and over the last three years.”

Furthermore, of the funds with a five-year history, most closed-end funds — nine out of 12 — and the single mutual fund beat both ETFs over five years, according to Esser. “Though only some of the CEFs have a 10-year history,” she says, outperformed the Bank of America Merrill Lynch Preferred Index over the 10-year annualized period.”