PREFERRED SHARES are mighty tempting right now because their yields are so much higher than most bond yields. For instance, iShares Preferred and Income Securities ETF currently boasts a yield of 4.4%, while Invesco Preferred ETF is kicking off almost 5% and SPDR Wells Fargo Preferred Stock ETF yields 4.5%.
But the reason is simple: They’re risky. Whether you invest in individual preferred shares or preferred stock ETFs, here are five risks to consider before investing:
1. Credit risk. On this score, there are four concerns. First, many issuers of preferred stock aren’t that financially strong. If they were, they would have issued cheaper forms of financing. Second, unlike the interest payments on bonds, dividend payments aren’t guaranteed. Third, in a bankruptcy, investors in preferred stocks get repaid after bondholders. Fourth, many preferred stocks have long maturities of 30 years or more—and sometimes no maturity date at all. While issuers may pose little credit risk in the near term, given enough time, many of them could get themselves in financial trouble.
2. Interest rate risk. Two factors conspire to make preferred stocks especially sensitive to interest rate changes: Most are issued with fixed dividends and most have very long maturities or no maturity. If market interest rates rise sharply, fixed-rate preferred stocks with long durations will plummet.
3. Call risk. Most preferred stocks have call provisions. Call provisions give issuers the right, but not the obligation, to call preferred stock on specified dates and at specified prices, which is usually the preferred’s par value. This creates three problems.
First, there’s asymmetric price risk. Other, noncallable debt has symmetric price risk. In other words, a 1% rise or fall in interest rates will result in roughly the same change in the price of a bond. But that’s not the case with callable preferred stock.
Why not? If interest rates rise, the price of preferred stocks will fall. But if interest rates fall and issuers have call rights, they’ll likely call their preferred stock and replace it with cheaper financing, so holders don’t get the full benefit of falling rates. On top of that, if an issuer’s credit rating improves, it will likely call its preferred stock and refinance it more cheaply. But if its credit rating deteriorates, it may not be in a position to call the stock. In that case, the price will fall due to the issuer’s deteriorating financial condition.
The second issue: There’s limited potential for price appreciation above par. Preferred stocks usually don’t trade much above their par values, and call provisions are the primary culprit. Suppose there’s a preferred stock that pays a dividend that’s significantly above current market yields. If the stock has call provisions, it could trade at a big premium to par—but only if its call date is in the distant future. If the call date is coming up soon, it would trade at or near par. Other investors simply aren’t going to pay much, if any, premium for a stock that’s about to be called at par.
(Keep in mind that, while preferreds are called “stocks,” they don’t participate in their issuer’s earnings growth unless they have participation or convertibility rights. Since most preferreds don’t have these rights, they don’t participate in the good fortunes of their issuer companies and hence, unlike a regular stock, there isn’t the same potential for long-term price gains.)
What’s the third issue? Callable preferred stocks pose reinvestment risk. If they’re called, holders lose their higher income streams—and they may have to reinvest their money at far lower yields.
4. Stock-like volatility. In the long run, preferred stock prices move primarily in response to changes in market interest rates and issuer creditworthiness. But in the short run, they tend to behave more like common stocks. Why? Stock market swings often reflect concerns about the economy and its impact on the financial stability of corporations—and those same concerns can drive preferred shares up and down.
For example, in the 2008 financial crisis, the prices of the two largest preferred stock ETFs, iShares Preferred and Invesco Preferred, declined 45% and 48% between May and October 2008. In 2020, the price of the iShares and Invesco funds declined by some 34% between February and March, before bouncing back. Preferred stocks have also had other, less stomach-churning pullbacks over the years. The bottom line: They’ve performed enough like common stocks over time that they shouldn’t be viewed as a bond substitute.
5. Concentration risk. Preferred stocks are highly concentrated in the financial and utilities sectors. That creates a diversification problem because you’re so overweighted in these sectors. How overweighted? As of late 2020, the larger preferred stock ETFs had about 65% of their portfolios invested in financial companies and about 13% in utilities. By contrast, financials and utilities represented some 10% and 3%, respectively, of the S&P 500-stock index.
Rick Moberg is the retired chief financial officer of a publicly traded software company. He has an MBA in finance, is a CPA and has a passion for personal finance. Rick lives outside of Boston with his wife. His previous articles include Happier at Home, Venturing Abroad and Six Tips.