With the Federal Reserve resuming its interest-rate cuts in recent months, the days of getting upwards of 5% yield in money-market funds and high-yield savings accounts in 2023 and 2024 are a distant memory, forcing investors to look a little harder for income. One source of hidden treasure could be in preferred stocks.
Preferred stocks, commonly issued by banks, utilities and real estate investment trusts, are a type of equity typically issued at a face value of $25 and offering regular dividend payments to shareholders. They have no maturity date like bonds, but companies can redeem shares for their par value at any point after their “call date.” The S&P U.S. Preferred Stock Index has sputtered to a 2.3% annualized five-year total return as of the end of November, but now offers a 6.9% dividend yield, which proponents of preferreds think are about as safe a bet as you can find in the high-yield market.
“People are talking about emerging-market debt, distressed debt, private equity debt. I keep bringing up, these yields you’re touting, I can find preferred stocks in some of the too-big-to-fail banks that are doing better than that,” says Ken Winans, the founder of Winans Investments and creator of his own proprietary preferred stock index. “You just cannot go wrong with a preferred in a major bank in this country that’s been around for 100 years.”
The Fed has cut rates three times since September, which typically brings fixed-income yields down as well and drives bond prices higher. The S&P 500 Investment Grade Corporate Bond Index is up 7.1% in price this year, but the preferred stock index is down 1.1%. Because of their perpetual durations, preferred stocks are typically more sensitive to long-term than short-term interest rates, which haven’t come down as much—the 30-year Treasury yield of 4.84% is higher now than it was at the start of the year. That’s led to an unusual circumstance with preferred stock yields looking more like high-yield bonds than investment-grade corporates today.
“We think that preferreds look better than high-yield at this juncture,” says Elaine Zaharis-Nikas, head of fixed income and preferred securities at Cohen & Steers. “You’re getting comparable levels of income for materially higher credits at a time when there’s still broader economic uncertainty.”
To pick out the best bargains, Adam Menzel and Benjamin Nobel have a “bargain table” on their Preferred Stock Alerts website with 141 different issues trading below their par values. They all yield at least 5% and meet a list of nine other criteria like offering at least five years of call protection from their listing dates, or having at least one investment grade credit rating from a ratings agency like Moody’s, Fitch or S&P Global.
Fourteen stocks on the list are different issues from California’s self-storage giant Public Storage that were all listed between 2017 and 2022. Its Series S preferred stock, for example, offered a 4.1% dividend when it started trading in January 2022 when interest rates were near zero, but as rates rose, it has declined from its $25 par value to $16.38 per share, giving it a 6.3% yield today. Essentially, they either offer a consistently high yield if their prices stay stagnant or the potential for a high price return if yields decline.
“You have all of these securities that are very high quality trading at $17 or $18 versus their par value of $25, just because they were issued in a much lower interest rate environment,” says Nobel, co-founder of BNK Invest, owner of Preferred Stock Alerts. “It’s sort of like a call option on a reversion to a lower interest rate environment in the future, so that if rates do come down, you have all that upside.”
For more pure yield plays, Martin Fridson, CEO and publisher of Income Securities Advisors, singles out three banks’ preferred stocks trading near their par values with high fixed coupons. A Bank of New York Mellon stock issued this year with a 6.15% coupon and currently yielding 6.04% is low risk, he says, thanks to the bank’s high credit quality supported by stable fee-based earnings, rather than a more precarious dependence on deposits.
A UMB Financial preferred yielding 7.2% is suitable for investors willing to take on moderate risk, with a Merchants Bancorp stock yielding 8.1% a solid bet for a higher risk tolerance. Fridson cites the Indiana-based Merchants Bancorp’s balanced earnings streams from traditional banking, multifamily mortgage lending and warehouse lending to set it apart from other smaller banks.
“Over the last couple of years, there have certainly been some problems in some of the regional banks, so you want a bank with strong credit characteristics. [Merchants] qualifies on several grounds,” he says.
Winans suggests a Citizens Financial stock with a 6.4% yield, but also thinks some of the best deals are outside the financial sector that makes up 69% of the S&P’s preferred stock index. He’s more weighted to real estate companies like Vornado Realty and Annaly Mortgage, energy firms like DTE and NGL Energy Partners and other stable businesses like Ford, which offers several preferreds at higher than 7% yields.
Most preferred stocks come with other perks, like qualified dividend tax rates which are equivalent to long-term capital gains rates and lower than ordinary income rates. Most also have cumulative dividend provisions which require any missed dividend payments to be paid to preferred shareholders before a company can distribute any dividends on its common stock. That provision could prove valuable if a severe downturn causes companies to cut dividends.
“If you really do think that the economy is going to fall apart, and you’re just scared to death of everything, I saw it in 2008, the accrual feature on dividends for a straight preferred is very powerful,” says Winans.
As a growth-oriented investor in common stocks, Winans doesn’t agree with bears, but is instead bullish because of the possibility that the Fed will continue to lower rates with inflation in check. Preferred stocks are likely to perform well and he’s continuing to increase his exposure, shifting away from corporate bonds.
“The prices just don’t make any sense at all, with rates coming down and Fed policy going where it is,” Winans says. “So much for it being an efficient market.”