Beware of preferred stocks

Ordinarily I don’t use my blog to give instructions–generally, I am more in need of instructions than qualified to give any. But one thing I do know a thing or two about is investments: for many years I was a security analyst (one who analyzes stocks and bonds for investment purposes) at a major trust company and for many more years, a private investor, which I still am.

I totally disagreed with an article in the August 2005 issue of the magazine Smart Money which promoted straight preferred stocks as a good investment for income. I thought it ill-advised for the magazine to publish the article (which I recall was written by a free-lance contributor) without any disclaimer such as "The opinions in this article are those of the author and do not necessarily..." I sent a letter to the editor of the magazine, which I am including below; not surprisingly, it was not published.

I forgot all about the matter until I came across an item in a recent issue of Barron’s on its "Other Voices" page in which an individual who had recently retired described how he handled his investments, both prior to and after retiring. He mentioned using preferred stocks–I assumed he meant straight preferred stocks since he didn’t indicate otherwise. (I don’t criticize Barron’s for not adding a disclaimer inasmuch as its "Other Voices" page is dedicated to outsiders, as its title implies.)

For whatever interest it might be to any who visit my blog, I include below the text of my letter to Smart Money. Please note the qualification in it that it only applies to INDIVIDUAL investors and to STRAIGHT preferred stocks.

My letter (which was sent some time in August 2005):

The promotion of preferred stocks to "goose your income" in the article "The Preferred Way to Boost Returns" in your August issue is very poor advice. There is almost never a justifiable case for an individual (as distinct from a corporation) to buy a straight (as distinct from a convertible) preferred stock. A preferred stock is a hybrid between a bond and a stock, and bears the disadvantage of each of those types of securities without enjoying the advantages of either.

Like a bond, a preferred does not participate in any future earnings and dividend growth of the company and any resulting growth of the price of the common. But the bond has greater security than the preferred and has a maturity date at which the principal is to be repaid.

Like the common, the preferred has less security protection than the bond. But the potential of increases of market price of the common and its dividends paid from future growth of the company is lacking for the preferred.

With the current historically low levels of interest rates, purchase of a straight preferred would be particularly foolhardy. The article comments that the three "Preferred Picks" provide current yields of just over 6%, adding that these yields are attractively higher than the current 4% on 10-year Treasuries. Only a snake oil salesman would make this pitch without pointing out what would happen to today’s market price of those "preferred picks" if interest rates should head back up to where they were in the early 1980's.

Suppose that an investor paid par ($100) today for one of the "preferred picks," which would give a current yield of just over 6%. Now suppose that in a few years 10-year Treasuries were to yield 13+% to maturity, as they did in 1981; these preferreds would yield at least 13%, which would knock their market price down to $46, for a 54% loss. (In all probability, they would yield some 2% more than the Treasuries–as the article suggests–or something like 15%, which would take the market price down to $40, for a 60% loss.) The important difference between preferreds and Treasuries (or any investment-grade Federal agency or corporate bond) is that the bonds would move up to par as their maturity date is approached, whereas the preferred, having no maturity date, might remain at these $40 levels for a long time.

The advantages of straight preferreds mentioned in the article (currently yield some 2% more than 10-year Treasuries, rank ahead of common stock in the case of bankruptcy, dividends are taxable at a maximum 15% rather than at ordinary income rates, as in the case of bond interest) are indeed paltry when compared to their inherent disadvantages described above.

The article comments, "Many investors would do better with a fund (of preferred stocks) than individual preferreds." This could be, if a manager of such a fund were astute at trading over a period of time. But better advice for individuals is : STAY AWAY FROM STRAIGHT PREFERRED STOCKS.