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Seeking Safe Income? Preferreds Are Worth a Look as Rates Rise.

The U.S. Treasury building in Washington.

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The backup in bond yields since the turn of the year has had disparate effects on interest-sensitive sectors, with bank stocks rallying but utilities mostly marking time. Preferred stocks mainly mirrored bonds’ moves, falling in price as the 10-year Treasury yield hit a 10-month high of 1.185% during Tuesday’s session.

The preferred market had resisted Treasury yields’ ascent during late 2020 as credit spreads contracted, Frank Sileo and Barry McAlinden, senior credit strategists at UBS Financial Services, noted in a blog post Tuesday. Indeed, prices of most of the preferred issues and preferred funds featured in our colleague Andrew Bary’s story last October were higher by year’s end.

But, as the old Wall Street saying goes, preferreds took the staircase up and the elevator down, the UBS strategists observed. Those with a $25 par value advanced 1.9% in December after a 2.5% gain in November, but have fallen 2.7% this year, through Tuesday. However, $1,000 par preferreds held up better, which the duo attributed to their having variable-rate dividends, while the $25 par varieties’ payouts are fixed, making them more sensitive to yield changes.

Outflows at exchange-traded funds also might be affecting preferreds, especially $25 par issues, which comprise most of the assets in preferred ETFs. The largest example, iShares Preferred & Income Securities (ticker: PFF), ended Thursday at $38.17, down from $38.51 at year-end but still up from $36.90 when our October story was published.

Bank preferreds, which dominate the market, should benefit from the rising yield environment, which has widened the spread between short- and long-term interest rates, a key determinant of banking companies’ profitability.

Sileo and McAlinden note that the Federal Reserve’s 2020 stress tests found that the banks would maintain strong capital levels in two severe hypothetical scenarios. As a result, the Fed is allowing banks to resume common-share repurchases in the first quarter. Buyback announcements will be a key factor investors will watch for in fourth-quarter earnings reports. The strategists don’t think that a resumption of buybacks will impair banks’ credit quality, which was bolstered by the suspension of repurchases that helped boost regulatory capital in the second and third quarters.

Bank preferred yields were mostly paltry, in the 3% range, at the end of 2020. A couple of issues highlighted last October, Capital One series K (COF-K) and Wells Fargo series Z (WFC-Z), still yield around 4.6%.

Closed-end preferred funds continue to provide significantly higher yields through leverage, which essentially puts the free money being provided by the Fed to work for investors. The CEFs featured in October, Nuveen Preferred & Income Securities (JPS) and First Trust Intermediate Duration Preferred & Income (FPF), yield 6.57% and 6.68%, respectively, while trading at moderate discounts of about 5% from net asset value.

Leverage is how another income vehicle—real estate investment trusts that invest in mortgage-related securities—produce extraordinarily high yields of over 10%. Preferred stocks issued by mortgage REITs are one of the tools that provide that leverage. But they are less risky than REITs’ common shares because their holders are paid first. The offset: They generally yield less than the common shares.

One of the more actively traded issues, Annaly Capital Management $25 par 6.5% series G (NLY-G), yields 6.68%, well below the 10.59% of Annaly common stock (NLY). But the Annaly preferred’s current yield still is more than three percentage points above the iShares iBoxx $ High Yield Corporate Bond ETF’s (HYG). Yields of 7%-8% and higher are available from riskier mortgage REITs.

Two things to note about mREIT preferreds:

Their payouts are taxed as ordinary income, like those of all REIT stocks, while most preferreds are subject to a top tax rate of 20% (plus a 3.8% Medicare surtax). This makes them more suitable for a retirement account shielded from current taxes, especially since taxes might rise in a Biden administration. In addition, most mREIT preferreds are callable at their $25 par value at a specified date (March 31, 2023, in the case of Annaly series G), which effectively caps their price.

Write to Randall W. Forsyth at [email protected]

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