By Brett Owens
Investors looking for income with low risk tend to gravitate heavily toward bonds, but their efforts are often better spent in preferred stocks. These "hybrid" securities commonly pay 5% or 6% but gyrate far less than common stocks - certainly less than most shares that offer a similar amount of yield.
So, what exactly is a preferred stock?
Preferreds are simply another way companies raise capital. However, unlike common stock whose value fluctuates with the success (or lack thereof) of the company, preferred stock trades around a "par value" much like a bond, and they pay fixed dividends - often yielding far more than the common shares.
Preferred stocks might not offer much in the way of growth, but you can see the value in being able to "hide out" while making, say, 6% versus just 2.5% for a 10-year T-note.
One downside? Preferred shares are less convenient to buy than regular stocks. However, the fund provider community has plenty of solutions, and in fact, investors typically buy exchange-traded funds (ETFs) and closed-end funds (CEFs) to get their fix.
Naturally, these funds vary in quality. Just look at the five-year performance of these four preferred funds - varying from 13% losses (including these massive dividends) to 60% gains.
4 Preferred Funds: The Good, The Bad and The Ugly
Global X SuperIncome Preferred ETF ( SPFF )
The Global X SuperIncome Preferred ETF ( SPFF ) is one of the highest-yielding preferred funds of any stripe - ETF, closed-end fund or mutual fund. At a yield of more than 7%, "SuperIncome" is far more than just a catchy name.
But there's a reason it's not called "SuperTotalReturn."
The SPFF has been a perennial loser over the course of its publicly traded life, thanks in large part to an aggressive but also narrow portfolio of just 50 or so stocks. For instance, the top two holdings - preferreds from GMAC Capital Trust and Barclays ( BCS ) - are each weighted at more than 5% each.
Credit quality, while not grand, isn't awful - investment-grade preferreds make up two-thirds of the fund - though it has been a riskier mix in the past. And the small number of holdings helps exacerbate performance by any bad apples.
There's no indication that SPFF will turn around what has been significant underperformance to its peers anytime soon.
VanEck Vectors Preferred Securities ex Financials ETF ( PFXF )
The VanEck Vectors Preferred Securities ex Financials ETF ( PFXF ) is an example of how the ETF industry sometimes launches products in answer to economic trends and events. In PFXF's case, it was a response to the drubbing that preferred-stock ETFs took during the 2007-09 financial crisis and bear market because traditional funds tend to be heavily weighted in banks and other financial-sector stocks.
PFXF does have a roughly 5% weight in insurers, so it's technically not utterly without financial exposure. Still, a 5% allocation to the space is far, far below that of most other preferred funds, which tend to sit at 70% exposure or more.
So, what does PFXF invest in? The fund has a 30% weight in real estate investment trust preferreds, with another quarter of the fund in utilities, and 13% in telecom. The fund also has exposure to the healthcare, agriculture and energy industries, among others.
PFXF has about double the holdings of SPFF, and its relatively low average credit quality (less than half the fund is investment-grade) helps keep its yield slightly elevated compared to most preferred ETFs (SPFF excluded). Yet that credit quality hasn't hampered performance, which is on par or better than many of its peers.
iShares International Preferred Stock ETF ( IPFF )
The iShares International Preferred Stock ETF ( IPFF ) is a collection of about 115 "international" preferred stocks, but understand that you're not exactly getting a ton of geographical diversity. Canadian preferreds make up 79% of the fund, with another 11% going to the United Kingdom. That leaves all of 10% among a handful of other countries, including 2%-plus exposure to the Bailiwick of Guernsey - a small set of islands in the English Channel with a population of about 66,000.
The IPFF has had a magical year, however, delivering 22% in total returns - a simply stellar one-year performance for a fund invested in preferred shares.
Just don't expect a repeat performance in 2018.
The past couple of years have represented a bounce-back from a simply dreadful 2014 and 2015 for this volatile fund - not the kind of trait you want from a preferred-stock holding. Moreover, this rebound has shrunk the IPFF's yield to a mere 3.3%, which means new money is staring at an utterly unimpressive income proposition at the moment.
Flaherty & Crumrine Preferred Income Fund ( PFD )
The Flaherty & Crumrine Preferred Income Fund ( PFD ) costs more than double the next-most expensive fund on this list. So, why would you even bother?
Well, have another look at our chart from above (this time with ticker symbols included), and you tell me.
Flaherty & Crumrine's PFD: You Get What You Pay For
Flaherty & Crumrine Preferred Income is a normal-looking portfolio of about 100 holdings with a decided tilt (77%) in financials. Top holdings include preferreds from the likes of JPMorgan (JPM) and Metlife (MET) .
The difference-maker is leverage - the ability to use debt to finance additional purchases within the fund to help generate extra yields and returns. That makes closed-end funds like PFD, which is levered by an additional 33%, a great place to invest in preferred stocks.
And My Favorite Preferred Share Fund Pays 7.3% Today
ETFs like PGX, PFF and SPFF often disappoint because their diversification actually expose you to unnecessary credit risk. The only way you lose with this vehicle is by giving your money to a driver who crashes your car. But the S&P 500 and NASDAQ are large enough that there's usually a company financially crashing into a brick wall at any moment in time .
And if we include the brick wall the financial world ran into ten years ago, these funds haven't even performed to their current yields.
I suspect PGX, PFF and SPFF probably won't actually return 5% or 6% annually over the next decade, either. Which why I recommend moving past a broad-based ETF in favor of a fund with an active manager working for you. There's extra yield to be had in preferred shares - but you should make sure you have an expert buying your stock to keep you safe and on the road.
My favorite preferred fund today - which I like even more than JPC - pays 7.3% today. It's an excellent deal because it's selling at a discount to net asset values (NAVs).
Why the buying opportunity? Recently, investors irrationally sold any and all closed-ends down to silly bargain prices. Some deservedly so, but this high quality preferred funds - with an excellent management team and track record - was swept away by the hysteria.
That's great for us. Low prices mean higher yields plus some upside as these funds gradually close their discount windows. And this 7.3% yield nets us 20%+ more income, more securely, than its ETF counterpart. Plus, the fund has a history of actually delivering these types of returns over the long haul (unlike the more popular ETFs).
Lesser-known high income plays like these are the cornerstones of my "no withdrawal" retirement portfolio strategy. Why rely on stock price appreciation in an inflated market when there are secure, high paying dividends you can simply live off of and keep your capital intact?
Most investors know this is the right approach to retirement. Problem is, they don'tknow how to find 7% and 8% yields to fund their lives.
That's why I specialize in finding safe, under-the-radar high income options. Click here and I'll explain more about my no withdrawal approach - plus I'll share the names, tickers and buy prices of my favorite preferred fund for 7.3% dividends .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.