What is the role of preferred stocks in a portfolio, if any?

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troysapp
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What is the role of preferred stocks in a portfolio, if any?

Post by troysapp »

Hello All,
I would very much to hear your thoughts about preferred stocks and how they should be used (or not) within a portfolio, if at all.

Specifically, I recently encountered a retired person with the self-stated risk tolerance as very low. His broker placed him with approx 80% preferred energy utility stocks (most callable within the year), 10% intermediate to long Treasuries, and 10% gold and gold mining stocks. All of these holdings reside within an IRA.

From my perspective he's taking on all sorts of risks without being aware of it, but I'd love to hear your thoughts.
MN Finance
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Re: What is the role of preferred stocks in a portfolio, if

Post by MN Finance »

If someone is conservative there's not much a broker can do to sell something appearing attractive and still make money. Preferreds are a common choice because of the appearance of safety but with plenty more risk than it appears. Notwithstanding the fact that the broker has carefully selected high quality preferreds, you can chart PFF and see how that did during the collapse to judge the risk.
larryswedroe
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Re: What is the role of preferred stocks in a portfolio, if

Post by larryswedroe »

IMO no role basically. If interested The Only Guide to Alternative Investments You'll Ever Need has chapter on them

Here's some recent evidence from piece I had written

A study found that for the period October 2003–February 2011 (the preferred index only begins in October 2003) period, the monthly return correlation between preferreds and stocks was 0.57, demonstrating that preferreds have significant exposure to equity risks. You can see evidence of this in the following data. The changes in the NAV for PFF for the five quarters beginning in July 2007 (when the financial crisis began), were -3.8 percent, -9.2 percent, +3.3 percent, -4.1 percent, and -28.0 percent. http://performance.morningstar.com/fund ... ture=en-US. Just when you need your fixed income assets to provide shelter from the equity storm, preferred stocks suffered large losses, similar to those experienced by junk bonds.
While the data is only available for a short period, it’s worthwhile to consider the following evidence. The annualized return for preferreds was 4.7 percent, just slightly higher than the 4.1 percent return on AAA -rated bonds, and below the 6.1 percent return on stocks. Since the monthly standard deviation of preferreds (6.4) was higher than for either AAA-rated bonds (1.1) or stocks (4.4), preferreds produced the lowest monthly Sharpe ratio, 0.07 versus 0.09 for stocks and 0.15 for AAA-rated bonds.
Of even greater concern is that a five-factor regression shows that not only do preferreds have significant exposure to equity risk (0.42 loading on the market factor) and significant exposure to value stocks (0.43 loading), but much greater exposure to default risk than high yield bonds. The loading on default for preferreds was 1.5, as compared to the default loading for 1-10 year high yield bonds of 0.54 and for 10-30 year high yield bonds of 0.77. All the figures are statisitically significant (t-stats above 2). In other words, preferreds had about three times the exposure to default risk as 1-10 year high yield bonds, and about twice that of 10-30 year high yield bonds.

Finally, while fixed rate non-callable Treasury debt makes an excellent diversifier for stock portfolios —because a weak economy, which can harm stock prices, generally leads to falling interest rates and rising bond prices — due to their call feature, preferred shares will not benefit as much, or even at all.
The bottom line is that their high yields are not sufficient reasons to justify investing in preferreds. If you want or need more risk than safe fixed income investments offer, take your risks on the equity side where you can control them more effectively, diversify them more effectively, and earn the risk premium in a more tax efficient manner. And your costs for fixed income assets will also be lower.
ralph124cf
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Re: What is the role of preferred stocks in a portfolio, if

Post by ralph124cf »

I am really annoyed that the broker put someone who stated that he has a very low risk tolerance into gold and gold mine stocks.

Did the client actually authorize this, or is it a discretionary account where the broker makes the trades and then tells the client what happened?

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White Coat Investor
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Re: What is the role of preferred stocks in a portfolio, if

Post by White Coat Investor »

troysapp wrote:Hello All,
I would very much to hear your thoughts about preferred stocks and how they should be used (or not) within a portfolio, if at all.

Specifically, I recently encountered a retired person with the self-stated risk tolerance as very low. His broker placed him with approx 80% preferred energy utility stocks (most callable within the year), 10% intermediate to long Treasuries, and 10% gold and gold mining stocks. All of these holdings reside within an IRA.

From my perspective he's taking on all sorts of risks without being aware of it, but I'd love to hear your thoughts.
I agree. There are lots of portfolios that are just fine out there. This is not one of them. The retired person you encountered needs a new portfolio and a new advisor.

My opinion of preferreds is the same as Larry's. My opinion of 80% of a portfolio in such a tiny slice of the investable market is that it is idiotic. I hold lots of asset classes in my portfolio (about a dozen) but my portfolio and that of this retired person don't overlap one bit. I hold nothing he holds and he holds nothing I hold.
1) Invest you must 2) Time is your friend 3) Impulse is your enemy | 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course
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nisiprius
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Re: What is the role of preferred stocks in a portfolio, if

Post by nisiprius »

troysapp wrote:Hello All,
I would very much to hear your thoughts about preferred stocks and how they should be used (or not) within a portfolio, if at all.

Specifically, I recently encountered a retired person with the self-stated risk tolerance as very low. His broker placed him with approx 80% preferred energy utility stocks (most callable within the year), 10% intermediate to long Treasuries, and 10% gold and gold mining stocks. All of these holdings reside within an IRA.

From my perspective he's taking on all sorts of risks without being aware of it, but I'd love to hear your thoughts.
That is awful.

The preferred stocks aren't even diversified. My understanding courtesy of ValueThinker is that preferred stocks are no longer a normal, mainstream avenue for companies to raise capital and you don't just automatically assume that every company that issues stock will issue both common and preferred, so maybe there isn't way to be diversified).

Gold is risky, although the gold advocates will give you an argument about that. Gold mining stocks are risky, and as far as I know, nobody will argue about that.

Long Treasuries are among the riskier kinds of high-grade bonds, with both inflation risk and interest rate risk. I belong to the school of thought, don't want to get into the debate but I believe a bond is free from interest rate risk if held to maturity, but inflation risk is very real and affects interest payments as well as market value. And the longer the term of the bond, the less likely it is that you actually will succeed in holding it to maturity.

If you can find out, I'd be curious to know the "broker's" credentials, i.e. is he a CFP or not, and is he supposed to be in a fiduciary position or not? Because I am still mildly curious whether the CFP code of ethics actually means anything, and mildly curious to know whether being in a fiduciary position actually means anything.
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Valuethinker
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Re: What is the role of preferred stocks in a portfolio, if

Post by Valuethinker »

nisiprius wrote:
troysapp wrote:Hello All,
I would very much to hear your thoughts about preferred stocks and how they should be used (or not) within a portfolio, if at all.

Specifically, I recently encountered a retired person with the self-stated risk tolerance as very low. His broker placed him with approx 80% preferred energy utility stocks (most callable within the year), 10% intermediate to long Treasuries, and 10% gold and gold mining stocks. All of these holdings reside within an IRA.

From my perspective he's taking on all sorts of risks without being aware of it, but I'd love to hear your thoughts.
That is awful.

The preferred stocks aren't even diversified. My understanding courtesy of ValueThinker is that preferred stocks are no longer a normal, mainstream avenue for companies to raise capital and you don't just automatically assume that every company that issues stock will issue both common and preferred, so maybe there isn't way to be diversified).
That's right. Debt is cheaper than equity for companies because interest payments are tax deductible, dividends are not (Modigliani & Miller theorems). So therefore it's better usually to issue bonds, even high yield or junk bonds, than to issue preference shares.

Exceptions. Companies like banks (perhaps utilities?) that need to maintain a certain amount of equity capital for regulatory reasons. On the credit rating side I think the agencies tend to view prefs as a form of debt, so issuing more 'equity' as prefs won't necessarily help your credit rating with Moody's, S&P, Fitch (not sure about that).
Gold is risky, although the gold advocates will give you an argument about that. Gold mining stocks are risky, and as far as I know, nobody will argue about that.

Long Treasuries are among the riskier kinds of high-grade bonds, with both inflation risk and interest rate risk. I belong to the school of thought, don't want to get into the debate but I believe a bond is free from interest rate risk if held to maturity, but inflation risk is very real and affects interest payments as well as market value. And the longer the term of the bond, the less likely it is that you actually will succeed in holding it to maturity.

If you can find out, I'd be curious to know the "broker's" credentials, i.e. is he a CFP or not, and is he supposed to be in a fiduciary position or not? Because I am still mildly curious whether the CFP code of ethics actually means anything, and mildly curious to know whether being in a fiduciary position actually means anything.
The portfolio sounds like an adaptation of that 25/25/25/25 portfolio that is always being talked about here-- the Brown portfolio?

Gold is meant to be hedge for high inflation. The Long Term Treasuries for deflation.

That's fine as it goes and 10% in each is not going to ruin portfolio performance-- drag it maybe, but not ruin it. However callable preference shares basically will get called if interest rates stay the same or go down, and extended (not called) if they go up. So the investor is left with a portfolio that if we have a normal recovery from here (Fed raises interest rates over time) they will not do well.

I agree about the utter irresponsibility of 'advising' someone to invest this way. This portfolio is just not diversified enough.

And preference shares have considerable credit risk, because they rank behind debt in a default or bankruptcy situation-- holders of prefs typically get very little in a restructuring.
Karamatsu
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Re: What is the role of preferred stocks in a portfolio, if

Post by Karamatsu »

It's interesting how this topic keeps reappearing. I guess I have about ten years of experience now with preferred stocks and, over the years, have in general come to more or less agree with Larry's position. They're not overtly evil, but they are flawed and it would be a mistake to consider them a substitute for bonds, which I think is the main point for an older, conservative investor.

My guess is that the advisor is choosing energy issues because either the person involved or the advisor still considers the financial sector too risky. Also many financial preferreds (95% of the preferred market these days) are non-cumulative, which might also make them unattractive, though cumulative issues have problems, too. The reason financials liked to issue preferreds is that US regulations allowed banks to treat preferred issuance as capital rather than debt! Dodd-Frank was supposed to abolish that, but existing issues may have been grandfathered, or perhaps the rules were amended by special interests later on. Industrials and utilities may like them because of the tax deduction, or just because they provide another option for those seeking income. Not sure. The idea of choosing issues callable within one year is probably that they have a juicy coupon but the market price is capped by the call risk, so if the issuing companies are healthy and the issues are trading at or above par, it makes the extra yield (versus what the market is offering on similarly rated debt) look like a potential free lunch. There may be something to that.

But of course it's a gamble, and I absolutely don't think they're a good idea as a major portion of a retired person's portfolio (or maybe anyone's portfolio), especially in this case, with everything concentrated on one sector. If you look at the holdings of PFF (CSV file) out of 315 issues total, there are 17 listed as utilities, but these represent only 10 utility companies. That's it. 80% of your portfolio on 10 companies in the same industry seems like a tremendous risk given the consequences if something goes wrong, either short-term (company/industry/sector problems) or the long-term (market and interest rate risk). I'd be inclined to accept lower yield for greater security, and that's what I do in my own portfolio. Preferreds are only 5% of the total these days, because I have not replaced them as they were called or sold (and don't intend to).
MN Finance
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Re: What is the role of preferred stocks in a portfolio, if

Post by MN Finance »

Being a broker implies just that, a broker being held to a suitability standard. And it's pretty tough to argue that someone violated a suitability standard, even if they self proclaim to be "conservative." Just because something like preferred stocks are not worth the risk adjusted returns for those that care to do the research, clearly doesn't make them unsuitable. They're widely held traditional investments.Being a fiduciary may increase the standard, but preferred stock or gold also don't mean they're not prudent. Being a cfp ads some moderate oversight, but again, we're talking about conventional investments. Doesn't matter that I might think there's a better way to take risk. Cfp can sell crappy annuities or earn commissions when turning an account if he/she is a broker, but their compensation method just needs to be disclosed. Imo, industry standards are used to review business practices, not necessarily implementation philosophy. Putting an 80 year old 100% in FB stock is obvious, most other situations are much less clear.
dl7848
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Re: What is the role of preferred stocks in a portfolio, if

Post by dl7848 »

Karamatsu wrote:It's interesting how this topic keeps reappearing. I guess I have about ten years of experience now with preferred stocks and, over the years, have in general come to more or less agree with Larry's position. They're not overtly evil, but they are flawed and it would be a mistake to consider them a substitute for bonds, which I think is the main point for an older, conservative investor.
Buffett seems to swing sweet deals on preferred stocks, which is probably one reason they are an enduring topic.
But of course it's a gamble, and I absolutely don't think they're a good idea as a major portion of a retired person's portfolio (or maybe anyone's portfolio), especially in this case, with everything concentrated on one sector.
They're quite popular with CEF investors as a diversifier of their bond CEFs. In that context, an overweight in financials wouldn't matter since they are balanced out by the highly diversified bonds. I own both types of CEF and even though sometimes all CEFs move as a group, the preferred ones seem to respond more to the equity cycle.
SGM
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Re: What is the role of preferred stocks in a portfolio, if

Post by SGM »

Generally not. They are tax advantaged for corporations not individuals. In 1989-90 Unisys preferred was in arrears 3 quarters. The company had 9 billion in sales. I felt the company would eventually pay the arrearage as common dividends cannot be paid until the preferred dividends are. A $10 stock owed $6 in dividends. The company started paying back the arrearage in several months. I have only seen the situation one other time with US Air preferred in the early but backed out when Warren B. declared his $400mm in USAA special preferred to be worthless (they were not). In 35 years I have not seen additional opportunities. This comes under the heading: major gamble.

A closed end fund with a deep discount to NAV might be worthwhile in small amounts in a tax deferred account. This comes under the heading : minor gamble.
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