Key Take Aways
- For yield-starved investors, preferred shares have been beneficial.
- The problem is many have chased yield and many preferred shares are overvalued.
- A careful look reveals there are many
preferred shares trading in excess of their call price - Lastly, many preferred share ETFs are skewed towards REITs and Financials – understand your sector exposures
It’s been difficult to find income and yield with global interest rates being suppressed by central banks and a lack of fiscal policy stimulus from the U.S. government.
It’s been a real tax on savers and investors that depend on fixed income to support their retirement. There’s nothing inherently wrong with preferred shares, but you need to look closely at the price you pay.
a. Preferred Shares Have Been a Solid Option
By keeping rates low, it was theorized, that investors would be forced into riskier assets. As a result we saw the run-up in Master Limited Partnerships – and their subsequent demise as oil and gas prices fell. We’ve also seen a run-up in preferred shares.
Below is a graph showing the performance of the iShares U.S. Preferred Stock ETF (PFF) for 2016.
It shows two things:
(i) high volatility with a decline of 8.5% to a low of 35.89, followed by a run-up of 12.4% from the February low; and
(ii) a good overall return with a year-to-date return of over 9%, both capital appreciation and dividends (current annual yield is about 5.6%).
(Source: Charles Schwab)
Jason Zweig points out in a recent Wall Street Journal article that PFF, which seeks to track the preferred stock index market, has taken in $2.2 billion in new money so far this year.
This inflow of new capital is likely the reason that the price of preferred stocks has risen, which almost never happens with most of their return coming from their fixed dividends. This year, however, almost half the 9% total return of the S&P preferred index has come from rising share prices.
b. Many Have Chased Yield and Many Preferred Shares are Overvalued
The top 10 holdings of PFF show a few things. First, nine of the top 10 holdings are financials, which represents a significant sector overweight.
Next, you can see the run-up six month returns driven by a demand for yield from yield starved investors. What you don’t see is the largest single holding is actually cash standing at 3.6% of PFF’s portfolio.
Investors are unaware of the differences between preferred shares, common equity and bonds. One key difference – preferred shares are often callable. In fact, 28% of PFF’s $17.5 billion in holdings are callable by the end of 2016, according to Jason Zweig.
Issuers of preferred shares have the right —not the obligation — to redeem those securities, taking them off the market in order to refinance at lower rates.
The threat of rising interest rates suggests that many of these callable preferred shares will actually be called at, typically, a price of $25.
c. Many Preferred Shares are Trading in Excess of Their Call Price
For Example, GMAC Cap Pfd shares, currently trading above $25.20 are callable on September 18, 2016 at a price of $25.
Jason Zweig points to another good example. He highlights the $950 million in preferred securities from Bank of America’s Merrill Lynch Capital Trust II, whose price shot up from $25 in February to $26.50 in June, far above the $25 par value.
Then, in July, the bank announced it would call the securities on August 15, 2016. Their price fell 2% in a day. This was one of PFF’s largest holding in July 2016.
d. Many Preferred Share ETFs are Skewed Towards REITs and Financials – understand your sector exposures
About 80% of preferred shares are issued by real estate investment trusts, banks and other financial companies.
Investors need to understand that they are not just gaining exposure to a ‘different financial product’, but they could be unwittingly increasing their exposure to real estate investment trusts, banks and other financial companies.
IMPORTANT NOTE: This blog is for informational purposes only and comments will not be posted on this site.
[1] Article by Jason Zweig (Wall Street Journal August 12, 2016).
[2] Jason Zweig (Wall Street Journal August 12, 2016).
[3] Jason Zweig (Wall Street Journal August 12, 2016).
FAQs About Why Many Preferred Shares Are Overvalued
Why have preferred shares been beneficial for yield-starved investors?
Preferred shares have been beneficial for yield-starved investors because they offer higher yields compared to other fixed-income instruments.
What is the impact of low global interest rates and a lack of fiscal policy stimulus on investors relying on fixed income?
Low global interest rates and a lack of fiscal policy stimulus have made it difficult for investors to find sufficient income and yield, which is particularly challenging for those relying on fixed income for retirement support.
What is the sector exposure of many preferred share ETFs?
Many preferred share ETFs are skewed towards real estate investment trusts (REITs) and financial companies, with about 80% of preferred shares being issued by these types of entities.
Why has the price of preferred stocks risen, contrary to their usual stable return from fixed dividends?
The price of preferred stocks has risen due to an influx of new capital into the market, as seen with the iShares U.S. Preferred Stock ETF (PFF) taking in $2.2 billion in new money in a given year.
What is the significance of preferred shares being callable?
Preferred shares being callable means that the issuers have the right, but not the obligation, to redeem these securities, potentially taking them off the market to refinance at lower rates.
Why is it important to understand the differences between preferred shares, common equity, and bonds?
Understanding the differences between these types of securities is crucial because preferred shares have specific characteristics, such as being callable, which can impact their value and return potential.
Is there anything inherently wrong with preferred shares, and how should investors approach them?
There is nothing inherently wrong with preferred shares, but investors need to be cautious and carefully consider the price they pay, especially given the current market conditions and the potential for overvaluation.
