Given the universal hunt for yield, many investors are asking me what I think of preferred stocks.
I believe that this asset class certainly has a place in yield oriented portfolios, but I wouldn’t overweight preferred equity funds at this time and would instead remain neutral. Why? While preferred funds are certainly providing a healthy, relatively high yield in a low yield environment, the extra yield comes with a lot of volatility.
Currently, preferred funds are offering a yield similar to that of a high yield bond fund, but preferred funds are also offering about 50% more volatility. For instance, the yield on the iShares S&P U.S. Preferred Stock Index Fund (NYSEARCA: PFF) is now approximately 6.5%, roughly in line with the yield of the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA: HYG). But at the same time, PFF’s three-year trailing volatility is more than 15% compared with less than 10% for HYG. Past performance is no guarantee of future results. For standardized performance for PFF, please click here.
To be sure, preferred stocks are generally more volatile than bonds and this makes sense given their lower place in the capital structure. However, there is another reason for the heightened volatility of preferred funds today.
The S&P U.S. Preferred Stock Index is composed of mostly financial companies. In fact, today, more than 85% of the issuers in the index are financials. This heavy concentration in the financial sector is also contributing to preferred funds’ volatility — the financial sector is now the most volatile sector in the market.
As such, preferred funds modeled on the index are essentially acting as proxies for financial stock funds, but with equity-like risk and bond-like returns. For those with a positive view on financials, this may be an acceptable risk-reward tradeoff. But as I currently hold an underweight view of global financials, I’m advocating a neutral allocation to the preferred stock asset class for now.
Russ Koesterich is the iShares Chief Investment Strategist and a regular contributor to the iShares Blog. You can find more of his posts here.
The author is long PFF and HYG.
The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling toll-free 1-800-iShares (1-800-474-2737) or by visiting www.iShares.com.
Index constituents are subject to change.
In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. Preferred stocks are not necessarily correlated with securities markets generally. Rising interest rates may cause the value of the Fund’s investments to decline significantly. Payment of dividends is not guaranteed. Removal of stocks from the index due to maturity, redemption, call features or conversion may cause a decrease in the yield of the index and the Fund. Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.
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