In a world where finding yield is a challenge, even a looming rate hike isn’t enough to get investors particularly excited about their bond portfolios. While some have turned to high yield bonds, preferred stocks have been mostly overlooked. But I think now may be a good time to take a closer look at preferred stocks.
Starting at the beginning
First thing’s first: what are preferred stocks? Put simply, they’re income-generating securities that have both stock and bond characteristics. When it comes to risk, they’re somewhere in the middle of the spectrum, between common stocks (more risky) and traditional bonds (less risky). Similar to a bond’s coupon payment, preferred stocks pay fixed or floating dividends. They can appreciate in value like a common stock, but they’re not as volatile as a common stock.
Preferred stocks may be most appropriate in a portfolio that is looking to achieve the following objectives:
1. According to Bloomberg, preferred stocks have historically experiencedthe highest yields in the investment grade universe, which makes them an attractive alternative or complement to corporate, municipal, and high yield debt securities.
2. Preferred stocks have lower historical correlations to traditional stocks and bonds, which means they tend to move in different directions when market conditions change.
3. Lower volatility. Because preferred stocks have a fixed dividend and may not fluctuate the way common stocks do when the market changes, they can potentially reduce the overall volatility of an equity or high yield portfolio. Keep in mind, however, that preferred stocks are more volatile than traditional fixed income and can carry more risk when financial sectors are under pressure.
Is now the time for preferred stocks?
Sometimes I’m asked if preferred stocks will remain an attractive asset class in a rising rate environment. While it is true that preferred stocks may see price declines as traditional long-term bonds would, the losses may be more than offset by the potential yield. Additionally, because we expect the rate rises to be gradual, we wouldn’t expect to see big downward spikes in preferred prices. Preferred stocks may also be attractive due to the fact that they’re issued mainly by financial companies, like banks. That’s because banks have historically tended to do well in rising rate environments, as they can benefit from making loans at higher interest rates.
If you’re looking for another source of income in your portfolio, you may want to consider preferred stocks.
Jane Leung is an iShares Asset Allocation Strategist for BlackRock.
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Preferred stocks are not necessarily correlated with securities markets generally. Rising interest rates may cause the value of an investment in preferred stocks to decline significantly.
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