Do Preferred securities let you sleep well at night?

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luckybamboo
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Do Preferred securities let you sleep well at night?

Post by luckybamboo » Mon Jan 15, 2018 1:03 am

My brother in law said that he recently liquidated all his investments and invested all the money into preferred stock and it lets him sleep well at night. He says its the best of both the worlds - less risky than stock and higher returns than bond.
He said that he put his kids college fund in it as well. Apparently, there are ETFs that invest in preferred stocks as well.
This seems too good to be true. I had not heard about preferred stock until he told me about it. I tried researching on the internet about it and found mixed reviews.
I have been on BH board almost daily for the past year. My thought is that if something is so good BHs must mention it as a good investment. But I haven't seen it mentioned in regular posts.
Can you please enlighten me on the Preferred Securities and are they worth considerring?

Tanelorn
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Re: Do Preferred securities let you sleep well at night?

Post by Tanelorn » Mon Jan 15, 2018 1:15 am

It depends what you want, but preferred stocks crashed just like equities in 2008, as measured by PFF, the main preferred etf. Plus since then, the broad equity market has outperformed preferred stocks by a huge margin. All the risk of equities in a crash, none of the upside in a bull market?

http://bigcharts.marketwatch.com/advcha ... e&state=13

lack_ey
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Re: Do Preferred securities let you sleep well at night?

Post by lack_ey » Mon Jan 15, 2018 3:49 am

Tanelorn wrote:
Mon Jan 15, 2018 1:15 am
It depends what you want, but preferred stocks crashed just like equities in 2008, as measured by PFF, the main preferred etf. Plus since then, the broad equity market has outperformed preferred stocks by a huge margin. All the risk of equities in a crash, none of the upside in a bull market?

http://bigcharts.marketwatch.com/advcha ... e&state=13
That's price return, not really fair given the high yield of preferreds.

Image
http://quotes.morningstar.com/chart/fun ... A%5B%5D%7D


There are a lot of issues with preferred stock, and in some ways they're not so much the best of both worlds but rather the worst of both worlds because of who the issuers are, what the market is, and how they're structured. Furthermore, you really want diversification if using preferred stocks, but there's no cheap fund; the popular iShares fund (PFF) has an ER of 0.46%, while the new Global X fund (PFFD) does have an ER of 0.23% but still has under $30 million in AUM. The underlying issues are not as liquid as you might expect from the largest common stocks.

Preferreds are equities but have the kind of capped upside and negative skewness of bonds—and generally more risky, lower quality bonds at that. Though they're ahead of common stock in the capital structure, they're behind bonds. If a company goes bankrupt, the bondholders will generally get paid some or a lot of pennies on the dollar after liquidation, while preferred stockholders typically get zero.

These tend to be long-term or indefinite maturity securities, but frequently with call provisions. If rates go down or the credit quality of the issuers increases, they may want to call them. On the other hand, you're left with the downside if rates increase or the issuer gets in trouble. Then when you look at who issues preferred stocks, it's highly biased to financials. So of course that means the 2008-2009 experience was particularly bad for preferred stocks based on sector exposure, but still, that is not as good for diversification more generally.

Furthermore, pricing may be a little unfavorable from a retail investor's point of view, as corporate buyers wet preferential tax treatment holding these (most of the dividends are not subject to tax for them), raising prices over what we'd get if all buyers of all securities were subject to the taxes retail investors face. Even when the dividends are qualified, the yields are so high, they are relatively tax inefficient.

I think it's reasonable to consider some preferred stock, maybe in a tax-advantage account, if you can convince yourself of whatever return or diversification benefit you see here relative to just shifting allocations of common stocks and bonds (you know, after fund fees). I suppose if market timing and you think common stock upside is pretty low and capped, then maybe the yield here can look relatively attractive.

But going all-in on preferred stock sounds like a terrible idea. Actually, this is maybe one scenario where holding individual issues may sometimes be better than a fund. If you screen for a few dozen at least, you may be reasonably diversified and might be able to get less sector and risk concentration than market-cap-weighted funds especially.

This isn't much of a sleep-well-at-night kind of investment.

Money Market
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Re: Do Preferred securities let you sleep well at night?

Post by Money Market » Mon Jan 15, 2018 6:51 am

lack_ey wrote:
Mon Jan 15, 2018 3:49 am
That's price return, not really fair given the high yield of preferreds.
lack_ey, do you know of a way to compute the chart with dividends reinvested? My only guess is to create a portfolio within Morningstar with $10k in the beginning year and manually click "CONFIRM TRANSACTION" for all the dividend events, then compute the returns manually. I find the need to do this for individual stock returns as well since other financial charts don't show annual returns like how mutual funds do.

Thanks

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Re: Do Preferred securities let you sleep well at night?

Post by nisiprius » Mon Jan 15, 2018 7:45 am

luckybamboo wrote:
Mon Jan 15, 2018 1:03 am
...He says its the best of both the worlds - less risky than stock and higher returns than bond...
Yes, they are less risky than stock and higher returns than bonds. No, they are not the "best of both worlds," they are just in between.

The big question is: are they any better than simply investing in a mixture of stocks and bonds? A mixture of stocks and bonds, of course, is less risky than stocks and (historically, in the past, and reasonably expected to have in the future, over long periods of time) higher return than bonds.

To put it bluntly, your friend has not done anything terribly foolish, but he's been probably been suckered into thinking that's he's gotten something special and better because it's unfamiliar to him--he thinks he's found some secret little investment treasures that are way better than bonds or common stocks that most people don't know about.

The big problem with preferred stocks is that nowadays they are weird little corner of the investment universe. Back in, say, the 1950s, when I took an elementary school field trip to the NYSE, you often heard the full phrase "common stocks" instead of just "stocks," because most companies issued both common and preferred stock, preferred stock was a "thing" as we say nowadays, and they explained the difference to gradeschoolers! Wikipedia notes that nowadays preferred stock is normally issue only by "financial institutions, REITs and public utilities" so by choosing preferred stock you are choosing a narrow and undiversified bit of the financial universe.

The composition of PFF is:

Image

and that's something of a problem regarding "sleeping at night" because in fact financials and real estate both did much worse than the stock market as a whole during 2007-2009, even taking dividends into account.

According to a no-cost online website, portfoliovisualizer.com, we can find a number called the "Sharpe ratio" for PFF, for the Vanguard Total Stock Market Index Fund, and the Vanguard Total Bond Market Index Fund. The Sharpe ratio is one possible measurement of risk-adjusted return. Whether you think it's appropriate depends on what you think of standard deviation as a measure of risk, but it's definitely a number to look at.

Over the time period PFF has existed, the Sharpe ratios were:

PFF iShares US Preferred Stock ETF 0.29
VTSMX Vanguard Total Stock Mkt Idx Inv 0.59
VBMFX Vanguard Total Bond Market Index 1.29

That's actually stunningly lower for PFF. Since we are interested in "sleeping," we are interested in risk, and what the numbers tell is that for the same amount of risk, PFF gave us much lower return than either a sector-diversified portfolio of common stocks, or bond. If we are interested in return, it tells us that in PFF we had to take much more risk to get the same return.
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Re: Do Preferred securities let you sleep well at night?

Post by nisiprius » Mon Jan 15, 2018 7:54 am

Here's another thing. Larry Swedroe and Jared Kizer wrote a good book called The Only Guide to Alternative Investments You'll Ever Need: The Good, the Flawed, the Bad, and the Ugly. If you want to take the next step in exploring preferred stocks, you should definitely read the chapter of the book that talks about them. It is chapter 12, in the section of the book where they describe investments they consider "flawed."
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Re: Do Preferred securities let you sleep well at night?

Post by Call_Me_Op » Mon Jan 15, 2018 7:57 am

luckybamboo wrote:
Mon Jan 15, 2018 1:03 am
My brother in law said that he recently liquidated all his investments and invested all the money into preferred stock and it lets him sleep well at night. He says its the best of both the worlds - less risky than stock and higher returns than bond.
He said that he put his kids college fund in it as well. Apparently, there are ETFs that invest in preferred stocks as well.
This seems too good to be true. I had not heard about preferred stock until he told me about it. I tried researching on the
He may indeed sleep well at night, blissfully unaware of the risks he is taking.
Last edited by Call_Me_Op on Mon Jan 15, 2018 7:58 am, edited 1 time in total.
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Re: Do Preferred securities let you sleep well at night?

Post by Kinkelly » Mon Jan 15, 2018 7:58 am

I own preferred stocks but I keep the at about 5-7% of my fixed income holdings. They have done well but if your friend thinks Preferred stock will
Allow him to sleep well at night, he has no idea what he is invested in.

Tanelorn
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Re: Do Preferred securities let you sleep well at night?

Post by Tanelorn » Mon Jan 15, 2018 8:36 am

lack_ey wrote:
Mon Jan 15, 2018 3:49 am
That's price return, not really fair given the high yield of preferreds.
Thanks, I didn't have the total return version handy. My main point was on risk and the 2008 crash, where price vs total return didn't matter much.

westrichj312
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Re: Do Preferred securities let you sleep well at night?

Post by westrichj312 » Mon Jan 15, 2018 9:41 am

check out the vrp as an alternative to the big preferred index pff. It is libor adjusted if interest rates rise in the future you will do a little better and have far more protection. It pays around 4.8% therefore, if you drop a million into it you will receive about 48 thousand per year to live off. Just like a bond fund if the fund itself goes down your income will rise with it as your principle drops.

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Re: Do Preferred securities let you sleep well at night?

Post by luckybamboo » Mon Jan 15, 2018 3:18 pm

@lack_ey - Thanks for the detailed explanation
@nisiprius - Thanks for your insights and analysis. I will definitely read the Chapter 12.

Now, I am a bit concerned about my sister as she is clueless about what her husband does. I will have to make her aware of the risks of this much concentration in preferred securities.
Thanks again to everyone.

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Re: Do Preferred securities let you sleep well at night?

Post by coachd50 » Mon Jan 15, 2018 3:28 pm

luckybamboo wrote:
Mon Jan 15, 2018 3:18 pm
@lack_ey - Thanks for the detailed explanation
@nisiprius - Thanks for your insights and analysis. I will definitely read the Chapter 12.

Now, I am a bit concerned about my sister as she is clueless about what her husband does. I will have to make her aware of the risks of this much concentration in preferred securities.
Thanks again to everyone.
Yeah...I might just point the brother in law and the sis to some info and let them make that decision rather then tell them about the risks, especially considering you had never heard of a preferred stock before this.

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Re: Do Preferred securities let you sleep well at night?

Post by luckybamboo » Mon Jan 15, 2018 3:32 pm

coachd50 wrote:
Mon Jan 15, 2018 3:28 pm
luckybamboo wrote:
Mon Jan 15, 2018 3:18 pm
@lack_ey - Thanks for the detailed explanation
@nisiprius - Thanks for your insights and analysis. I will definitely read the Chapter 12.

Now, I am a bit concerned about my sister as she is clueless about what her husband does. I will have to make her aware of the risks of this much concentration in preferred securities.
Thanks again to everyone.
Yeah...I might just point the brother in law and the sis to some info and let them make that decision rather then tell them about the risks, especially considering you had never heard of a preferred stock before this.
You are right. That's what I will do.

coachd50
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Re: Do Preferred securities let you sleep well at night?

Post by coachd50 » Mon Jan 15, 2018 3:48 pm

luckybamboo wrote:
Mon Jan 15, 2018 3:32 pm
coachd50 wrote:
Mon Jan 15, 2018 3:28 pm
luckybamboo wrote:
Mon Jan 15, 2018 3:18 pm
@lack_ey - Thanks for the detailed explanation
@nisiprius - Thanks for your insights and analysis. I will definitely read the Chapter 12.

Now, I am a bit concerned about my sister as she is clueless about what her husband does. I will have to make her aware of the risks of this much concentration in preferred securities.
Thanks again to everyone.
Yeah...I might just point the brother in law and the sis to some info and let them make that decision rather then tell them about the risks, especially considering you had never heard of a preferred stock before this.
You are right. That's what I will do.
Maybe something along the lines of "Hey, I was looking into preferred stocks you had talked about, and I am not quite as confident as you are that they are the best of both worlds." What about them is giving you a sense of security?" And then let him explain why he feels they are "safer".

In the strictest sense, they are "safer" in that the owners have a superior claim to assets than a common stock holder, and that the dividends must be paid to preferred prior to common stock holders. But that does not make them immune to value drops.

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Re: Do Preferred securities let you sleep well at night?

Post by OnTrack » Thu Dec 20, 2018 10:13 pm

westrichj312 wrote:
Mon Jan 15, 2018 9:41 am
check out the vrp as an alternative to the big preferred index pff. It is libor adjusted if interest rates rise in the future you will do a little better and have far more protection. It pays around 4.8% therefore, if you drop a million into it you will receive about 48 thousand per year to live off. Just like a bond fund if the fund itself goes down your income will rise with it as your principle drops.
I don't understand the bolded part above. With a bond fund that has gone down in price due to rising interest rates, that may be true because as older bonds mature the proceeds can be reinvested in new bonds earning higher interest. But most preferred stocks do not have a maturity date so they cannot be reinvested at a higher rate.

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Re: Do Preferred securities let you sleep well at night?

Post by snailderby » Thu Dec 20, 2018 10:25 pm


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Re: Do Preferred securities let you sleep well at night?

Post by Valuethinker » Fri Dec 21, 2018 5:40 am

OnTrack wrote:
Thu Dec 20, 2018 10:13 pm
westrichj312 wrote:
Mon Jan 15, 2018 9:41 am
check out the vrp as an alternative to the big preferred index pff. It is libor adjusted if interest rates rise in the future you will do a little better and have far more protection. It pays around 4.8% therefore, if you drop a million into it you will receive about 48 thousand per year to live off. Just like a bond fund if the fund itself goes down your income will rise with it as your principle drops.
I don't understand the bolded part above. With a bond fund that has gone down in price due to rising interest rates, that may be true because as older bonds mature the proceeds can be reinvested in new bonds earning higher interest. But most preferred stocks do not have a maturity date so they cannot be reinvested at a higher rate.
Note thread restarted from Jan 2018.

Tanelorn
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Re: Do Preferred securities let you sleep well at night?

Post by Tanelorn » Fri Dec 21, 2018 6:53 am

Preferred shareholders, especially higher yield chasers, have gotten really burned this past week or so. Credit markets are a lot more nervous now than they were, say a month ago, when the broad stock market was down more.

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Re: Do Preferred securities let you sleep well at night?

Post by DEZ1 » Fri Jun 14, 2019 8:17 am

Just heard Rick Ferri on the white coat investor podcast say he keeps all his fixed equity except for a 2 year emergency fund in pffd a mutual fund for preferred stock

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Re: Do Preferred securities let you sleep well at night?

Post by UpperNwGuy » Fri Jun 14, 2019 8:20 am

I would not sleep well at night if my investments were in preferred securities.

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Re: Do Preferred securities let you sleep well at night?

Post by Boglegrappler » Fri Jun 14, 2019 9:43 am

lack_ey has the general gist of preferreds pretty well expressed.

From a corporate point of view, I always viewed preferreds as a "capitulation" financing. Usually the company needed cash because of marginally profitable (or unprofitable) operating conditions. They also usually had completely maxed out their corporate credit lines and also were up against their de facto limits in the bond markets. Either covenants, or the markets, were not going to extend additional credit as a source of cash.

And, logically, their stock price was usually not all that highly valued, so they either couldn't sell new shares to get the cash, or didn't want to because of the low valuation.

So this is where the preferred shares came in. It was a way to raise cash that didn't involve adding more debt, which existing lenders didn't want, and which might lower their already shaky credit rating. And it didn't really dilute the existing shareholders other than the cost of the preferred dividend. The preferred dividend isn't tax deductible for the company, but it gets more cash in for the moment.

Utility preferreds are perhaps a bit of an exception to this critique, because the utility commissions, I believe, allow rate adjustments to recover some of this additional cost of capital.

The takeaway is that a preferred stock investor needs to be keenly aware of what he holds, and the underlying economics of the company. It really isn't something that an amateur investor should forge ahead into based upon the "yield" number being higher. There are some exceptions to that general admonition, but broadly speaking, that's what you're dealing with with straight (as opposed to convertible) preferreds. They are the "lesser of evils" choice for a company who has limited financing alternatives available, and which needs the cash. Caveat Emptor.

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Re: Do Preferred securities let you sleep well at night?

Post by Broken Man 1999 » Fri Jun 14, 2019 10:14 am

I have one preferred stock, currently worth $19,958.40.

Since that is a small part of my portfolio, I sleep very well at night. If I held $199,584.00 of the stock, I wouldn't sleep well at night.

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Re: Do Preferred securities let you sleep well at night?

Post by rich126 » Fri Jun 14, 2019 10:18 am

I haven’t bought many preferreds but during the 2008 crash there were some nice opportunities. I didn’t jump in heavily but stuff like the Wells Fargo preferred L 7.5% $1000 par traded under $400. I got it around $700 and plan to keep it for some time.

The problem with most preferreds now are that anything of quality is likely trading over par value. The one I mentioned above is over $1330. People are stretching for yields. I’m not a fan of buying preferreds or bonds about par or face value.

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Re: Do Preferred securities let you sleep well at night?

Post by nisiprius » Fri Jun 14, 2019 11:04 am

luckybamboo wrote:
Mon Jan 15, 2018 1:03 am
...He says its the best of both the worlds - less risky than stock and higher returns than bond...
That's pretty much nonsense. Consider this: a mixture of stocks and bonds is also "less risky than stock and higher returns than bonds."

You have stocks. High risk, high return. You have bonds. Low risk, low return. And you have various somewhat offbeat securities that sound intriguing because they are unfamiliar, that have characteristics somewhere in between stocks and bonds. For example, "dividend stocks" are slightly bond-like stocks. "Preferred stocks" are more bond-like stocks. "High-yield bonds" are stock-like bonds. None of these are "the best of both worlds," they are just "a mix of both worlds" or "sorta in between two worlds."

One big knock on preferred stock is that it's no longer issued by most companies. In the 1950s, say, most companies issued both common and preferred stocks. Nowadays, it is a kind of specialty thing and is almost entirely issued by financial companies. So you have a diversification problem, because investing in preferred stocks amounts to putting most of your eggs in one out of the eleven business sector baskets.

Christine Benz comments that "Moreover, preferreds are invariably issued by heavily leveraged companies, meaning they can skid in value amid a weakening economic environment."

These in-between securities should not be compared to regular stocks alone, or to regular bonds alone. The burden of proof to show how and why they are any better than the nearest comparable mix of regular stocks and bonds.

For example, compare a preferred stock fund, Principal Preferred Securities, PPSAX, portfolio 1, with two alternatives. Portfolio 2 is the most boring possible traditional fund, Vanguard Balanced Index, 60% US stocks, 40% US bonds. Portfolio 3 is, similarly, a mixture of stocks and bonds but this time we've raised the stock allocation to 80/20.

Source

Image
Image

First of all, I don't see much "sleep well" in the preferred fund, portfolio 1. It had a drawdown of -42% in 2008-2009. That's less than that of regular stocks, which decline -52%. But it's a lot more like stocks than like bonds, which had less than a -3% decline.

Second, the boring old 60/40 fund both fell less (-33% versus -42%) and earned more (average annual return 6.88% versus 5.85%; growth of $10,000 over the full time period $24,430 versus $21,441). The mix of stocks and bonds had more return and less risk than the preferred stock fund, by every measure.

Third, if we are willing to accept the 42% drawdown of preferred stocks, try comparing it to the 80/20 mix, portfolio 3, yellow. The 80/20 mix was a pretty close match for the preferred stocks in all aspects of risk, yet had considerably higher return.

In short, there isn't the faintest suggestion that the preferred stocks were any better than a mix of regular stocks and bonds.

Preferred stocks are not some wonderful diamond in the rough that only a few people know about. The reason you don't read much about them here is that once you get past "more return than bonds, less risk than common stocks" few Bogleheads have seen anything interesting about them. They might not be the worst choice your brother-in-law could make, but it's hard to see how they are any better than mainstream choices, like the three-fund portfolio, or a LifeStrategy fund, or a Target Retirement fund.
Last edited by nisiprius on Fri Jun 14, 2019 11:20 am, edited 4 times in total.
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Re: Do Preferred securities let you sleep well at night?

Post by Wiggums » Fri Jun 14, 2019 11:15 am

I don’t have any preferred stock.

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Re: Do Preferred securities let you sleep well at night?

Post by capjak » Fri Jun 14, 2019 11:39 am

Definitely would try to keep it at a lower % of Portfolio and many follow stocks on the way down but not on the way up.

I have several individual preferred stocks (no index funds) that are lightly traded ( i.e. not liquid, a few less than100 shares per day) and a few that are 20 year past call that continue to distribute 6% Qualified Dividend (even in the crash). I keep them locked up and do not intend to trade them. $300,000 provides apps $17,000 annual dividend.

Examples (Utilities mostly): AILLL-Ameren Illinois, WFC-L-Wells Fargo, CNTHP-Connecticut Light/Power, NI-B NiSource,CHS-M farm owned COOP,

Edit: Added link to "The basic goal of our website is to make it as easy as possible for income investors to easily find good income investments via the QuantumOnline (QOL) website" http://www.quantumonline.com

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Re: Do Preferred securities let you sleep well at night?

Post by TomatoTomahto » Fri Jun 14, 2019 11:55 am

Unless I miss my guess, there is the unmistakeable aroma of a salesman being wafted towards me. I doubt someone as unsophisticated as your BIL, as evidenced by his calling preferred the best of both worlds, would have opted to go all in on preferred stock without external encouragement.

That he is gullible is probably as big a concern as his choice of investment vehicle.

Good luck to you and your sister.
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