Income investing: potential perils and benefits of preferred stocks

February 16, 2016 Categories: Portfolio Corner
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2015 was a tough year for investors who were seeking both growth and income from their portfolio. While income might have been delivered, growth was tough to find.

Income-producing asset class yields 1-yr returns

Sources: Morningstar, Factset, S&P.
Preferred stocks represented by S&P Preferred Stock TR Index; U.S. equity represented by S&P 500® Index; U.S. Bonds represented by Barclays U.S. Aggregate Bond Index; REITs (Real Estate Investment Trusts) represented by FTSE EPRA/NAREIT Developed Index; High yield represented by Barclays Global High Yield Index; Utilities represented by S&P Utilities Index; International equity represented by MSCI ACWI Ex-USA Index; Infrastructure represented by S&P Global Infrastructure Index; MLPs represented by Alerian MLP Indexes.

That’s challenging in the long run because it is the growth element of the portfolio that allows the income to be sustainable over time. Recall,

Total return = Income + Growth (i.e., capital appreciation)

Balancing growth and income

For example, an investor with a $100k portfolio that earned 3% in income but lost -8% in capital “appreciation” over a year would have experienced a total return loss of -5%. The portfolio began the year with $100k and ended with a value of $95k.

What’s that hypothetical income-seeking investor to do?

Basically the investor has two options:

  1. hold constant the percentage drawn from the portfolio
  2. hold constant the dollar value drawn from the portfolio

But, both options eventually degrade the value to the investor in different ways.

Option #1, a constant percentage, erodes the current income available. After all, if the investor continues to draw 3% from the portfolio, they are drawing from a lower base, which will yield a smaller dollar amount ($2.85k vs. $3k).

Option #2, a constant dollar value, erodes the portfolio principal, which in turn decreases the ability to generate future income. In other words, if the investor wants or needs $3k (like the previous year), they will be pulling a higher percent off the portfolio (3.2% vs. 3%).

So, balancing growth and income is critical in the quest for sustainability.

Preferred stocks: the positive outlier in 2015

The obvious income-producing outlier in 2015 was preferred stocks, as shown in the chart above. They delivered on the income and the growth side of the equation. But before being tempted to allocate a portion of a client’s portfolio to preferreds, let’s do a quick review.

What are preferreds?

Preferred stocks can be a nice complement to an income portfolio as they are a hybrid security with elements of both stocks and bonds. While they are listed as an equity, income investors like them because they typically pay a dividend. Often, those dividends are fixed – or known – producing a higher, more stable income stream for investors over common stock. They are also higher up in the capital structure than common shares but lower than bonds in case of liquidation.

On the surface, these benefits seem like a great answer to the income-seeking investor’s challenges. But, as with any investment, there are two sides to the coin and savvy investors should be aware of the risks of investing in preferred stocks – particularly right now.

Buyer beware

First, companies can defer or skip dividend payments. Depending on the type of preferred stock (e.g. callable, convertible, cumulative, non-cumulative, floating coupon, fixed coupon, trust, and variable coupon) companies can choose to not pay/defer a dividend without the risk of default. This flexibility is one of the reasons companies prefer issuing preferreds. But, it should give income-seeking investors pause and evaluate if the risk of deferred or non-existent dividend payments threatens their income priority.

Second, sector concentration. As of 12/31/15, the Financials sector made up 84.1% of the S&P Preferred Stock Index. Right now, investing in preferreds basically means investing in financials. Investors need to decide whether they are comfortable with that level of concentration in one sector right now.

S&P U.S. Preferred Index Sector Breakdown

The bottom line

Preferred stocks can be a nice complement to an income portfolio but it is important to understand the benefits and potential pitfalls before investing. We believe balancing various sources of income is best, particularly in the current market environment.

The Alerian MLP Index is a composite of the 50 most prominent energy master limited partnerships calculated by Standard & Poor’s using a float-adjusted market capitalization methodology. The index is disseminated by the New York Stock Exchange real-time on a price return basis.

The Barclays Global High Yield Index provides a broad-based measure of global high yield fixed-income markets, representing the union of the U.S. High Yield Index, Pan-European High Yield Index, U.S. Emerging Markets High Yield Index, CMBS High Yield and Pan-European Emerging Markets High Yield Index.

Barclays U.S. Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities. (specifically: Barclays Government/Corporate Bond Index, the Asset-Backed Securities Index, and the Mortgage-Backed Securities Index).

FTSE EPRA/NAREIT Developed Real Estate Index is a global market capitalization weighted index composed of listed real estate securities in the North American, European and Asian real estate markets.

Morgan Stanley Capital International All Country World (MSCI ACWI) Ex-U.S. Index: A market-capitalization-weighted index designed to provide a broad measure of stock performance throughout the world (with the exception of U.S.-based companies), including both developed and emerging markets.

S&P 500® Index: An index, with dividends reinvested, of 500 issues representative of leading companies in the U.S. large cap securities market.

The S&P Global Infrastructure Index provides liquid and tradable exposure to 75 companies from around the world that represent the listed infrastructure universe. To create diversified exposure across the global listed infrastructure market, the index has balanced weights across three distinct infrastructure clusters: Utilities, Transportation, and Energy.

The S&P U.S. Preferred Stock Index is designed to be an investable benchmark representing the U.S. preferred stock market. Preferred stocks are a class of capital stock that pays dividends at a specified rate and has a preference over common stock in the payment of dividends and the liquidation of assets.

The S&P Utilities Index is a capitalization-weighted index containing 31 electric and gas utility stocks (including multiutilities and independent power producers).

This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

Strategic asset allocation and diversification do not assure profit or protect against loss in declining markets.

The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Indexes are unmanaged and cannot be invested in directly.

Russell Investments is a trade name and registered trademark of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide, including Russell Financial Services, Inc., member FINRA. Russell Investments is part of London Stock Exchange Group.

Copyright © Russell Investments 2016. All rights reserved.

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