Preferreds, hybrids, convertible preferred??

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jefmafnl
Posts: 501
Joined: Sun Mar 25, 2007 7:11 am

Preferreds, hybrids, convertible preferred??

Post by jefmafnl »

Mom (93) managed her own investments successfully for many years after Dad died. She invested a substantial portion of her assets in individual preferred stocks. I'm aware that many experts and Bogleheads do not recommend these, but she was convinced that they served her well, and her portfolio has in fact produced the income she needs, without excessive volatility.

A few years ago she also purchased shares of the the iShares U.S. Preferred Stock ETF (PFF). Now that this fund is changing its investment policy, she has asked my advice as to what this change means.

Currently the fund tracks an S&P DowJones index of U.S. preferred stocks. After a transition period (Feb. through Oct. 2019) it will track an ICE Data Indices index of exchange-listed, U.S. dollar-denominated "preferred stocks with amounts outstanding over $100 million, convertible preferred stock with at least $50 million face amount outstanding, and hybrid securities with at least $250 million face amount outstanding, that meet minimum price liquidity, trading volume, maturity and other requirements..."

Does this change make this ETF much riskier? Somewhat riskier? Or not riskier?

Thanks!

J
Valuethinker
Posts: 42165
Joined: Fri May 11, 2007 11:07 am

Re: Preferreds, hybrids, convertible preferred??

Post by Valuethinker »

jefmafnl wrote: Sun Jan 13, 2019 8:32 am Mom (93) managed her own investments successfully for many years after Dad died. She invested a substantial portion of her assets in individual preferred stocks. I'm aware that many experts and Bogleheads do not recommend these, but she was convinced that they served her well, and her portfolio has in fact produced the income she needs, without excessive volatility.

A few years ago she also purchased shares of the the iShares U.S. Preferred Stock ETF (PFF). Now that this fund is changing its investment policy, she has asked my advice as to what this change means.

Currently the fund tracks an S&P DowJones index of U.S. preferred stocks. After a transition period (Feb. through Oct. 2019) it will track an ICE Data Indices index of exchange-listed, U.S. dollar-denominated "preferred stocks with amounts outstanding over $100 million, convertible preferred stock with at least $50 million face amount outstanding, and hybrid securities with at least $250 million face amount outstanding, that meet minimum price liquidity, trading volume, maturity and other requirements..."

Does this change make this ETF much riskier? Somewhat riskier? Or not riskier?

Thanks!

J
Probably no more risky than it is now. The convertible securities it will now invest in may give it more upside, but also greater sensitivity to equity market moves.

But it's a risky portfolio - there is no doubt about that.

1. if you look at 2008-09, these sorts of things fell, by a lot. Since they sit at the very end of the credit ranking (just above common stock) if something goes wrong, the holders usually get little or nothing after the more senior creditors are paid.

Also if preference dividends, then the company is not legally obligated to pay with failure to do so leading to an Event of Default (the latter true if an interest bearing instrument like a bond). So the company will withhold payment if things get sticky.

2. They are mostly issued by financial institutions and/ or by high risk companies with contingent future cash flows. For example a biotech company that has a lot riding on future drug approval stages but is in "burn mode" right now.

Thus as and when a credit crunch comes, they hurt.

Financial institutions can issue these to bolster their regulatory capital (preference shares, that is).

Because of the tax deductibility of interest, a non-financial company is better to issue convertible bonds or other hybrid securities.

Larry Swedroe does not recommend them for all these reasons plus the tax inefficiency for individual investors.

You know all of the above so it may be that's not a consideration.
naha66
Posts: 198
Joined: Sun Jul 14, 2013 6:02 pm

Re: Preferreds, hybrids, convertible preferred??

Post by naha66 »

Don't forget Rick Ferri does recommend holding up to 20% of a perferred stock fund/etf in his Core 4 income portfolio.
Valuethinker
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Joined: Fri May 11, 2007 11:07 am

Re: Preferreds, hybrids, convertible preferred??

Post by Valuethinker »

naha66 wrote: Mon Jan 14, 2019 3:38 am Don't forget Rick Ferri does recommend holding up to 20% of a perferred stock fund/etf in his Core 4 income portfolio.
That boils down to whether one thinks credit risk is orthogonal as a factor to equity risk ie separable within a portfolio.

If it is, then a High Yield bond fund would give better diversification of exposure and modestly greater protection in a downturn. HY bonds have really replaced hybrid type instruments for a lot of non financial companies e.g. for private equity LBOs. They offer the issuer greater tax benefits (deductibility of interest) and potentially cheaper finance.

With a pref fund you will probably get a heavy concentration in financials. That sectoral risk has to be a concern.

If credit risk is highly correlated with equity risk, then you are better off simply splitting the pref fund investment between ordinary equity index funds, and bond funds.

Investing for income is largely an illusion - the investor is better off simply selling some stock when they need cash - it is total return that matters. Given the power of that illusion, a reasonable alternative is to own some of a dividend income fund although again you have strong sectoral risk (heavy concentration in utilities, etc). It's not rational, for example, to own Apple and Microsoft (which do pay dividends) but not Amazon and Facebook and Google (which do not, but do do stock buybacks).

(that's a separate point from whether to own Intel & Microsoft vs. other tech stocks on valuation grounds. Those 2 tend to look "cheap" compared to the other super tech stocks because the market perceives that they will have lower future growth. Thus they tend to pay decent dividend yields (lower share price and greater propensity to pay out cash to investors).
jminv
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Re: Preferreds, hybrids, convertible preferred??

Post by jminv »

jefmafnl wrote: Sun Jan 13, 2019 8:32 am I'm aware that many experts and Bogleheads do not recommend these, but she was convinced that they served her well, and her portfolio has in fact produced the income she needs, without excessive volatility.

Currently the fund tracks an S&P DowJones index of U.S. preferred stocks. After a transition period (Feb. through Oct. 2019) it will track an ICE Data Indices index of exchange-listed, U.S. dollar-denominated "preferred stocks with amounts outstanding over $100 million, convertible preferred stock with at least $50 million face amount outstanding, and hybrid securities with at least $250 million face amount outstanding, that meet minimum price liquidity, trading volume, maturity and other requirements..."

Does this change make this ETF much riskier? Somewhat riskier? Or not riskier?

Thanks!

J
Preferreds fell more than the overall market during the last recession but also had a sharp rebound so it's good your mother was able to handle the drawdown. PFF, for example, is more volatile than the S&P500. PFF also has a 0.46% ER which is sort of high, although not for a preferred ETF.

I would imagine they are switching index providers to reduce what they pay to the benchmark provider. This has become increasingly important with the race to reduce ERs and the benchmark payments are not marginal. The second reason, given that they are changing the types of securities they can hold, could be to increase the types of companies they can hold since regular preferred are favored by financial companies. As far as the individual holdings market cap part, the preferred stock component market cap requirements are identical to the current index. The main effect of this rebalancing will be to increase the holdings of utility securities and decrease those of financials which I suppose means it will be somewhat more diversified than it is under the current index which could mean it will become marginally less risky. I would probably stick with it since it's what your mother is comfortable - and wants to - invest in. I don't personally care for the income illusion, since it's total return that matters, but it seems simpler to leave things as is. I'd guess that this is held in taxable? in which case there could be substantial capital gains if you decided to go for something else instead.
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