Even though this blog has seen nearly a 30% increase in readers since the beginning of the year I actually don’t receive many questions from readers anymore. Maybe it’s because my posts are so intimidating or maybe there is another reason. Either way, I always welcome reader questions since I can usually turn them into a blog post. Please contact me if you’re interested in submitting a question.
This week’s question comes from reader PR and he asks:
What is your take on preferred stocks as a way to increase income due to their supposedly paying a higher dividend? There is a fund PGX I heard about.
I can completely understand where reader PR’s question is coming from. Today’s low interest rate environment means that investors can no longer get the same rate of return they’ve gotten accustomed to with products like government debt and high quality corporate bonds. Many investors nearing retirement(or already there) are turning to alternative investments in order to squeeze more yield out of their fixed income. And that’s where a fund like PGX steps in.
PGX is actually an ETF that holds the preferred stock of many different companies. It has a 6.45% SEC Yield and a reasonable expense ratio of .5%(not good, but not horrible either). It is well diversified among many preferred stocks but let’s take a look a closer look at what this ETF actually holds.
What are Preferred Stocks Anyways?
Technically, preferred stocks are classified as stocks but they’re more akin to a hybrid stock and bond combination. A preferred stock gets priority in receiving dividends and precedence over common stockholders(after bond holders and other creditors though) in the event of a liquidation of corporate assets(like in a bankruptcy). But in return for this preferential treatment, the stock is normally issued at a fixed price paying a fixed dividend.
The price of the shares are also subject to interest rate risk and the risk of the stock being called. If interest rates go up, the price of the shares will go down. If interest rates go down, the shares can be called at par(ie $10 for a $10 share) and replaced with new preferred stock at a lower rate. This is called asymmetric risk since you’re taking on the risk of a long duration product if rates rise while also capping potential gains(with a put to call) if rates were to fall.
Normally, we would expect symmetric risk from a fixed income product like government debt since a 1% increase in interest rates would result in approximately the same change as a 1% drop in interest rates. That’s not how preferred stocks work though.
Alternative Investments Don’t Usually Add Up
I’m actually surprised that I haven’t seen more questions about preferred stocks popping up now that the dividend investing fad has died down a little bit. Investors are always looking for more yield but the thing you have to keep in mind is the stock market is damn efficient. If preferred stocks are paying a 6.45% yield, there’s a reason why: they have real risk.
I review a lot of alternative investments looking for that one diamond in the rough but the math just never seems to add up. Although the yield may be higher on preferred stocks than bonds, the two asset classes have almost nothing in common. Sure you could get a 6.45% return by investing in PGX but don’t be surprised if the volatility is more like that of the stock market.
The graph below actually illustrates how PGX(orange) underperformed bonds(green) during the past 6 years and even did worse than the stock market(purple) during 2008-2009 financial crisis. So basically you’re investing in a fund that has higher volatility than equities and a lower return than bonds. Doesn’t make much sense does it?
Keep it Simple
I like investing in things that I understand. Preferred stock isn’t the most complicated thing out there but it’s not that simple either. Generally, when I don’t fully understand how an investment works, there are probably lots of smarter people on the other end of that deal waiting to take advantage of me and my money. Investing in what you know isn’t the sexiest investment style but it usually makes the most sense.
I’ve always kept an open mind to alternative investments but it seems like it’s always a better deal for the salesmen on the other side. I don’t mind doing the research and figuring things out for myself instead of listening to what someone else tells me about an investment. I use empirical data(like the chart above) and investment theory in order to decide whether an investment makes sense. If professional money managers can’t even come remotely close to consistently picking winning stocks and predicting things like interest rates why would I ever think that I can?
So What’s an Investor to do?
If you couldn’t tell by now, I think investing in preferred stock is a bad idea. Too many people tend to compare things like dividend yield to the return of fixed income products like bonds and CD’s – they are not the same. But like I said earlier, I understand why investors are looking for more yield and preferred stocks may seem attractive on the surface.
This probably isn’t the answer that people want to hear but there’s really not a whole lot you can do right now. There will never be a magic investment that combines the high return of stocks and the low risk of bonds. If there did exist such a thing, you would be very late to the party.
Readers, do you own any preferred stock or preferred stock ETF’s? Have you ever considered investing in it or is this the first you’re hearing about it?
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-Harry @ PF Pro