BOSTON ( TheStreet) -- Citigroup (C - Get Report), MetLife (MET - Get Report) and Public Storage (PSA - Get Report) sell preferred stock that's often overlooked by investors but can offer yields that beat those of bonds and dividend-paying stocks, says Mitch Schlesinger, chief investment officer at FBB Capital.
Preferred securities tend to lack liquidity, require rigorous credit analysis and face being retired as interest rates hover near record lows. But for astute investors, the rewards can be high. Citigroup's preferred shares, for instance, currently yield more than 7%.
|Mitch Schlesinger, investment chief at FBB Capital
"As part of a broader portfolio, they are more like longer-dated bonds so you get a higher yield," says Schlesinger. "If you only buy preferreds, you're going to have a higher-yield portfolio but you're going to have a riskier portfolio because longer-dated bonds tend to be more volatile. So you have to balance the desire to get a higher yield with the knowledge that they are riskier instruments overall."
To accomplish that, Schlesinger weeds out preferred stocks by purchasing them at a discount, which offsets the risk of the securities being "called," or retired at a certain price -- typically lower. Schlesinger notes a
preferred issue that yields minus 15%, which can be attractive to some investors who believe Goldman isn't likely to retire the preferred stock.
"I think we'll avoid that one," he says. "It's always shocking to see some yields going negative on the call. It could be the market looking at the company saying they're not likely to call it, in which case people are betting it'll stay in existence and continue to pay at the higher rate, in this case 6.2% for Goldman. I prefer to buy at a discount and that offsets the risk to being called and actually losing money."
Based in Bethesda, Md., FBB Capital has more than $450 million in assets. Schlesinger says the firm has an income bias in its portfolios, although he recommends that investors only devote a small part of their portfolio to preferred securities. FBB Capital conducts its own in-house credit-quality research.
"Credit quality is paramount," Schlesinger says. "Because many times the issue is subordinate to other bonds, they tend to carry a lower credit rating. Sometimes you'll see a solid investment-grade company issuing preferreds that are rated at or close to junk status. You're really concerned with, like a bond, their ability to consistently pay the dividend on the preferred and avoid bankruptcy."
While most preferred securities are fully taxable as ordinary income, much like a bond, Schlesinger says a number are eligible for the lower dividend rate. While that rate is expected to climb slightly from 15%, some preferred securities become more favorable than others.
"We don't know what the dividend rate will be next year or even this year, really, but assuming that dividends are favored in some way in the tax structure, then some of these may be eligible for a more advantageous tax rate as well," Schlesinger says.
The pitfalls of investing in preferred securities can be a turnoff to many individual investors. Preferred stock is largely issued by banks, real estate investment trusts and utilities, limiting the exposure to other sectors. Liquidity, or the trading volume of the issue, is a "major, major factor," Schlesinger says.
"Preferred securities tend to be less liquid than other securities issued by the same companies, meaning they don't have the trading volume that you might want to see," he adds. "Subsequently, the bid/ask spread can be wider than on a straight bond, which makes them riskier. But that's why you get paid more."
The current interest-rate environment also makes investing in preferred securities like a high-wire balancing act. Lower rates increase the likelihood that a company can call the issue to lock in financing at a lower rate. In addition, the
is working to raise rates through quantitative easing, which will pressure prices.
Individual investors may find it difficult to perform credit analysis on their own. In that case, Schlesinger recommends the
iShares S&P U.S. Preferred Stock
exchanged traded fund, as it offers diversification and perpetual management with a distribution yield higher than 6%.
For other investors looking to take on the risk of preferred stocks for higher income, Schlesinger offers five companies where credit isn't a concern. He says many of the preferred securities will be held in accounts at the firm until they're called.