Malkeil on Preferred Stocks - what's the Bogleheads take?

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Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by dowse » Mon Jun 20, 2016 7:29 am

This morning's WSJ has the latest from Burton Malkeil this morning on preferred stocks, or more specifically, funds of preferred stocks as an alternative to bonds http://www.wsj.com/articles/the-preferr ... 1466374302. I'm wondering what the BH take is on this. Is it worthwhile considering allocating some portion of one's portfolio to these type of funds?

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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by nisiprius » Mon Jun 20, 2016 7:44 am

Weird. A blast from the past... when we toured the New York Stock Exchange in elementary school in the 1950s, someone explained to use the difference between "preferred stocks" and "common stocks," and the full phrase "common stocks" was customarily used in full for the asset class we now just call "stocks..."

People are always promoting oddball asset classes whose chief virtuie is that they are slightly unfamiliar and therefore you are likely to believe whatever the presenter says about them because you haven't read otherwise anywhere else...

Preferred stocks, like junk bonds, are, to me, neither fish, flesh, fowl, nor good red herring. I do believe that in "The Intelligent Investor" (not at hand at the moment) either Graham or possibly annotator Jason Zweig said that they are generally suspect because they are one of those awkward in-between things that possibly partake of the worst characteristics of both... preferred stocks do not give you any contractual return like bonds, but neither do they give you the upside potential of common stocks. I had sort of thought that preferred stocks were now a specialty class issued only by a small number of companies for special-case reasons, and purchased mostly by institutions because of some obscure tax characteristics relevant to institutions.

I can't seem to read the full article. Does Malkiel give any compelling reasons for thinking that the behavior of preferred stocks (which are bond-like stocks) is going to be hugely different and better than the equivalently risky mix of plain old common stocks and plain old bonds? [Added] OK, the "Google search on title" trick worked for this article. He spends the whole article simply describing the asset class, stating (acknowledging) that they are a hybrid part-stock-like part-bond-like class, acknowledges they crashed in 2008-2009 and that they are riskier than bonds... and says not one word to explain why preferred stocks would be any better that just using the equivalent stock/bond mix.

In short, he gives absolutely no reason for considering convertible stocks other than "they exist" and "maybe you don't know about them."

One more detail... Swedroe and Kizer discussed preferred stocks in "The Only Guide to Alternative Investments You Will Ever Need: The Good, the Flawed, the Bad, and the Ugly" and they include them in the "flawed" section. Probably worth reading if one were going to seriously go in for investing in them.
Last edited by nisiprius on Mon Jun 20, 2016 7:57 am, edited 2 times in total.
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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by nisiprius » Mon Jun 20, 2016 7:45 am

P. S. Vanguard used to have a preferred stock fund, but it was discontinued... I don't know anything more than that.
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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by dowse » Mon Jun 20, 2016 8:00 am

Hmm - when I click on the link I can see the full article. Here is the title to search on "The ‘Preferred’ Path to Higher Returns". The main argument he is making is that an ETF comprised of preferred stocks currently returns almost 6% and behaves more like a bond than a stock. He argues that such an investment deserves a place in the fixed-income portion of a portfolio. The main drawbacks are higher volatility to interest rates and lack of diversity as they tend to be heavily weighted in financial stocks.

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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by nisiprius » Mon Jun 20, 2016 8:02 am

:oops: The Bogleheads wiki has a good article about them. Few companies issue them now because junk bonds work better for the company, they are mostly issued by financial institutions, and the article says:

"In a sense then preference stock often combines the worst features of corporate bonds (frequently callable; lack of upside) with those of common stock (little protection in bankruptcy; possibility dividend will be omitted). In addition portfolios of preference shares are highly concentrated around financial companies, thus reducing diversification."

A pity that Malkiel doesn't address any of those issues in is article.

http://www.bogleheads.org/wiki/Preferred_stock
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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by dowse » Mon Jun 20, 2016 8:04 am

I guess I was wrong on the link. Just tried it again, and it is behind a paywall. I must have been logged in to WSJ at the time. So far, in a quick search I don't see a non-paywall version showing up. Hopefully it will later or at least other BH readers will chime in with their summaries. Sorry for the confusion.

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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by azanon » Mon Jun 20, 2016 8:06 am

nisiprius wrote:P. S. Vanguard used to have a preferred stock fund, but it was discontinued... I don't know anything more than that.
They still have it - Vanguard Convertible Securities - VCVSX, investing minimum $3000. Convertible bonds/Preferred Stocks fund.

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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by SGM » Mon Jun 20, 2016 8:15 am

Preferred stock have a safer dividend than common stocks. However,you also will not participate in any increases in the underlying value of the common stock. The dividends are fully taxable to individuals and not taxable to corporations. Common stock dividends cannot be paid if the preferred dividend and all arrearages are not paid. Preferred stocks are subordinate to corporate bond if there is a bankruptcy.

If you are prepared to take the extra risk they might be useful. If the underlying corporation is strong there is less risk. I suspect most BHs would feel that the added risk is not sufficiently compensated.

I owned a small amount of a preferred stock fund in a tax deferred account a few years ago but sold it for an index fund. Expense ratios were a little higher than funds I normally use and I wanted the diversification.

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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by nisiprius » Mon Jun 20, 2016 8:16 am

dowse wrote:...The main argument he is making is that an ETF comprised of preferred stocks currently returns almost 6% and behaves more like a bond than a stock. He argues that such an investment deserves a place in the fixed-income portion of a portfolio...
They behave more like a bond than a stock when everything is going well for the company... but that's not a good thing. You are taking some degree of stock risk, but you are not being rewarded with participation in the good years.

The question is, what happens when the risk shows up because the individual company, or the stock market as a whole, is not doing well. In that case, they behave more like a stock than a bond. The burden of proof is on Malkiel to show why the overall risk/reward proposition is any better for preferred stocks, and why the pattern of risk is more suitable, than portfolios that are mixes of (common!) stock and investment-grade bonds. My rationale for holding bonds is that they behave "like bonds" all the time, particularly during times like 2008-2009. Do preferred stocks?
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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by larryswedroe » Mon Jun 20, 2016 11:24 am

The topic is covered in my book on alternatives.

Bottom line is for individuals I cannot think of good reason to own them.

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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by nedsaid » Mon Jun 20, 2016 11:37 am

The yield chasing at all costs continues. Interest rates are very low and it is amazing to see seasoned professionals like Malkiel who should know better finding themselves in a yield panic. Grab for extra yield however you can get it no matter the risks. Damn the torpedoes, full steam ahead.
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Malkiel's WSJ piece today - Use preferred stocks instead of bonds

Post by neomutiny06 » Mon Jun 20, 2016 3:47 pm

[Thread merged into here, see below. --admin LadyGeek]

http://www.wsj.com/articles/the-preferr ... 1466374302

I never hear Bogleheads discuss preferred stocks. Malkiel says that some ETFs are available. Which are those, and is this ever recommended?

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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by SGM » Mon Jun 20, 2016 3:55 pm

I don't think it is terribly risky to have a small part of your portfolio in preferred stock of solid companies. The risk of default is minimal if the companies are solid. The expected return of stocks going forward is rather low so the fact that preferred stocks do not go up in value when the underlying common stock goes up in value is less likely to happen. It seems to me since preferred stock dividends are not taxable to corporations there is somewhat of a floor to their valuations too.

I wouldn't consider this a core long term investment, but it may be safe enough to use for a few years. I would probably put it in my tax advantaged account because the dividends are taxable to individuals..... if I were to buy it.

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Re: Malkiel's WSJ piece today - Use preferred stocks instead of bonds

Post by donfairplay » Mon Jun 20, 2016 4:17 pm

Preferred stocks and their ETFs are not a direct replacement for bonds. Most of the ETFs are financial preferred stocks, and much like financial common equities/shares - they take the stairs up and the elevator down. Take PFF (ishares preferred stock etf) which was introduced at the 2007 peak, it dropped 63.5% from April 5, 2007 to February 20, 2009.

They can be a part of a portfolio, the tax treatment is nice, and the ETFs are the way to go even though they're financial-sector heavy. You have a few options:

PFF (ishares S&P US Preferred Stock Index Fund) - more preferred stocks than PGX, slightly lower expense ratios

PGX (Powershares Preferred Portfolio) - less preferred stocks than PFF, higher ER, but a surprisingly higher morningstar star rating (if that even means anything today)

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Re: Malkiel's WSJ piece today - Use preferred stocks instead of bonds

Post by Blueskies123 » Mon Jun 20, 2016 4:17 pm

I use bonds to reduce the volatility of my portfolio and give me something to live on for 8 years should the stock market tank big time. Someone would have to show me that preferred stock is no more correlated to stocks than bonds. My recollection of 2008 was that preferred stock went down as much as stock went down but I have not checked.

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Re: Malkiel's WSJ piece today - Use preferred stocks instead of bonds

Post by RyeWhiskey » Mon Jun 20, 2016 4:24 pm

Preferred stock is not a suitable substitute for bonds. Here's the wiki article: https://www.bogleheads.org/wiki/Preferred_stock
Bogleheads Wiki wrote:For the reasons above, investment in preference stock is usually not recommended. The risk-return tradeoffs are unfavourable for individual investors and those seeking corporate credit risk exposure are better advised to invest in corporate bond funds, whilst those seeking equity upside are advised to invest in diversified index funds made up of common stock (like Vanguard Total Stock Market).
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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by saltycaper » Mon Jun 20, 2016 4:29 pm

SGM wrote:I wouldn't consider this a core long term investment, but it may be safe enough to use for a few years.
If it's only safe enough for a few years, it's probably not safe at all.
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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by LadyGeek » Mon Jun 20, 2016 4:29 pm

FYI - I merged neomutiny06's thread into here.

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RyeWhiskey makes a good point (2 posts up from here).
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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by Ostentatious » Mon Jun 20, 2016 4:39 pm

Can't get the full article. Do I need to pay to read just one article? These paywalls must come down.

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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by Levett » Mon Jun 20, 2016 4:40 pm

I guess Malkiel thinks it's "different this time." :wink:

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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by SGM » Mon Jun 20, 2016 6:11 pm

saltycaper wrote:
SGM wrote:I wouldn't consider this a core long term investment, but it may be safe enough to use for a few years.
If it's only safe enough for a few years, it's probably not safe at all.
No way is not safe at all. I pointed out a few things in my prior posts that tend toward safety. You cannot pay a common dividend unless you are up to date on payments to preferred stock owners. This is huge incentive for companies to continue paying the preferred dividend. Preferred stock dividends are tax free to corporations and this will somewhat buoy the price of the preferreds.

The preferreds are more risky than corporate bond funds in regards to bankruptcy. But just how safe were GM bonds?

I think that the risk of losing to inflation is one of the greater risks associated with bonds and bond funds.

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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by saltycaper » Mon Jun 20, 2016 6:49 pm

SGM wrote:
saltycaper wrote:
SGM wrote:I wouldn't consider this a core long term investment, but it may be safe enough to use for a few years.
If it's only safe enough for a few years, it's probably not safe at all.
No way is not safe at all. I pointed out a few things in my prior posts that tend toward safety. You cannot pay a common dividend unless you are up to date on payments to preferred stock owners. This is huge incentive for companies to continue paying the preferred dividend. Preferred stock dividends are tax free to corporations and this will somewhat buoy the price of the preferreds.

The preferreds are more risky than corporate bond funds in regards to bankruptcy. But just how safe were GM bonds?

I think that the risk of losing to inflation is one of the greater risks associated with bonds and bond funds.
I get what you're saying, but I'm an either/or guy. Either an investment is appropriate or it's not, after taking into account individual circumstances and the rest of the portfolio. It may only be appropriate for certain investors in certain circumstances, and it may only be appropriate when used in combination with other investments, but appropriate only for an arbitrary few years? IMO, no.
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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by Tanelorn » Tue Jun 21, 2016 6:40 am

On the bright side, most preferred stock dividends are qualified, which makes them better than bonds for taxes on their dividends.

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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by grabiner » Tue Jun 21, 2016 9:51 pm

dowse wrote:Hmm - when I click on the link I can see the full article. Here is the title to search on "The ‘Preferred’ Path to Higher Returns". The main argument he is making is that an ETF comprised of preferred stocks currently returns almost 6% and behaves more like a bond than a stock.
The payments are not guaranteed, so there is more credit risk.

And even when a preferred stock does behave like a bond, it behaves like an infinite-maturity bond. Vanguard Long-Term Corporate Bond Index is yielding 4.3%; it holds mostly bonds rated A and BBB, with a maturity of 24 years and a duration of 14, representing a moderate credit risk and a lot of interest-rate risk. You don't gain that much more by buying preferreds, which have higher credit risk than the same corporations' bonds, and have even more interest-rate risk.
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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by abuss368 » Wed Jun 22, 2016 12:01 am

Preferred stocks are not a substitute for bonds in my opinion. Bonds provide safety and income to an investment portfolio.
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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by ryman554 » Wed Jun 22, 2016 8:40 am

abuss368 wrote:Preferred stocks are not a substitute for bonds in my opinion. Bonds provide safety and income to an investment portfolio.
Succinct. But are they a substitute for stocks, when one takes into account the total RoR?

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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by abuss368 » Wed Jun 22, 2016 9:57 am

What worries me is investors who hold Burton Malkeil in high regard may follow this advice.

Should a market pull back (or worse) occur, this could end badly. Especially for any investors close to retirement that may incorrectly substitute bonds for preferred stocks in their investment portfolios.
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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by Valuethinker » Thu Jun 23, 2016 7:12 am

ryman554 wrote:
abuss368 wrote:Preferred stocks are not a substitute for bonds in my opinion. Bonds provide safety and income to an investment portfolio.
Succinct. But are they a substitute for stocks, when one takes into account the total RoR?
Not really. They have equity risk, to be sure, but you don't get the potential upside that you have with ordinary common stock.

It's a general principle here that returns from your portfolio via selling assets are equivalent to income (except for tax). And therefore there's no reason to buy an instrument with less upside (than stocks) or more downside (than bonds) simply to get a higher income.

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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by ryman554 » Thu Jun 23, 2016 8:32 am

Valuethinker wrote:
ryman554 wrote:
abuss368 wrote:Preferred stocks are not a substitute for bonds in my opinion. Bonds provide safety and income to an investment portfolio.
Succinct. But are they a substitute for stocks, when one takes into account the total RoR?
Not really. They have equity risk, to be sure, but you don't get the potential upside that you have with ordinary common stock.

It's a general principle here that returns from your portfolio via selling assets are equivalent to income (except for tax). And therefore there's no reason to buy an instrument with less upside (than stocks) or more downside (than bonds) simply to get a higher income.
I don't disagree.

But you are describing my father's investing strategy to a "T". Fully invested in cash (ugh, waiting for market to crash -- since 2012!), preferred stocks (because he can make 6%), and some closed end mutual funds (don't know where to begin).

Now, I believe SS + pension cover virutally all of his expenses, so it's likely not an issue for him. My biggest worry is that his investments have not increased in the past 10-15 years, and he's fully bought into the preferred stock strategy.

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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by OnTrack » Thu Jun 23, 2016 8:56 am

My biggest concern with preferred stocks (non-convertible) is that they are interest rate sensitive and they have no expiration date. So an investor cannot just wait for them to mature to have the principle returned in a rising interest rate environment.

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Re: Malkiel's WSJ piece today - Use preferred stocks instead of bonds

Post by Valuethinker » Thu Jun 23, 2016 9:21 am

Blueskies123 wrote:I use bonds to reduce the volatility of my portfolio and give me something to live on for 8 years should the stock market tank big time. Someone would have to show me that preferred stock is no more correlated to stocks than bonds. My recollection of 2008 was that preferred stock went down as much as stock went down but I have not checked.
Preferred stocks have a greater correlation with equities than most bonds do (HY and convertible bonds perhaps an exception).

They'd have to, because if a company goes bankrupt, the preference shareholders only get paid if all the creditors are satisfied (which seldom happens). That's an equity risk.

Also as per Grabiner's post, because most preference shares don't have a redemption date (but some can be called by the issuer, a nasty feature for the investor) they are very "long duration" ie maximally sensitive to interest rate changes (up or down). The same would be true of a bond with an infinite life.

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Re: Malkiel's WSJ piece today - Use preferred stocks instead of bonds

Post by stratton » Thu Jun 23, 2016 5:43 pm

Valuethinker wrote:Also as per Grabiner's post, because most preference shares don't have a redemption date (but some can be called by the issuer, a nasty feature for the investor) they are very "long duration" ie maximally sensitive to interest rate changes (up or down). The same would be true of a bond with an infinite life.
So how would these compare to Consols which were just redeemed in the last few years. Some of them dating back to the 18th century.

-Both are very "long duration."
-Both can, and did with the consols get "called."
-The consols had their interest rates lowered by Parliament.
-Consols are gilts (?) so they were UK treasuries. Preferred stock is corporate bonds.

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Re: Malkiel's WSJ piece today - Use preferred stocks instead of bonds

Post by grabiner » Thu Jun 23, 2016 7:40 pm

stratton wrote:
Valuethinker wrote:Also as per Grabiner's post, because most preference shares don't have a redemption date (but some can be called by the issuer, a nasty feature for the investor) they are very "long duration" ie maximally sensitive to interest rate changes (up or down). The same would be true of a bond with an infinite life.
So how would these compare to Consols which were just redeemed in the last few years. Some of them dating back to the 18th century.

-Both are very "long duration."
-Both can, and did with the consols get "called."
-The consols had their interest rates lowered by Parliament.
-Consols are gilts (?) so they were UK treasuries. Preferred stock is corporate bonds.
The consols have all the risks of preferred stock, except for the credit risk. The call risk depends on the terms; for these consols, redemption at par was always possible by Act of Parliament.

The main risk with the consols is the very long duration, and it is worse for consols than for preferred stocks because of the lower yields. A consol at a 3% yield (that is, it pays GBP 300 per year and is worth GBP 10,000) has a duration of 33 years. Even with positive convexity (duration decreases when rates rise), that is a huge risk; if yields rise to 4%, the consol loses 25% of its value.
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Re: Malkeil on Preferred Stocks - what's the Bogleheads take?

Post by Tanelorn » Fri Jun 24, 2016 6:40 am

Rising rates and Fed hikes aren't on the top of my risk list for today, or the rest of this year.

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