Atlanta, GA – Investors seeking to maximize their income growth through reinvesting and compounding high yields often consider preferred stock. However, the comparison with other alternatives, such as senior loans, high-yield bonds, and high-yielding stocks like utilities, real estate, and energy-based MLPs, raises important questions about its place in an income factory.
When considering “fixed income” investments, it’s crucial to evaluate what is being “bet on” when making the investment. Corporate loans and high-yield bonds carry the primary risk of default, while traditional bonds carry significant interest rate risk. In contrast, equity investors bet on a company’s ability to not only stay alive and pay its debts but also thrive and grow. As such, equity investors take on both credit risk and the additional entrepreneurial risk of failing to grow its business and earnings. This underscores the importance of equity investor returns exceeding those of credit investors.
Preferred stock sits midway between debt and equity, resembling debt in terms of fixed features but lacking the potential for growth like regular equity. The absence of an expiration date for preferred stock raises the risk of its dividend yield becoming out of sync compared to prevailing interest rates. Additionally, in the event of a default, preferred stock ranks at the bottom of the liability stack, receiving payment only after senior secured loans and unsecured bonds are repaid in full.
Despite these considerations, preferred stock has none of the upside of regular equity but also lacks the protections offered to loans and bondholders in the event of a company defaulting. This explains why most preferred stock is issued by well-established investment-grade companies with a lower risk of default relative to non-investment grade corporations that issue senior loans and high-yield bonds.
From a protection standpoint, preferred stock investors are no different than stockholders if the issuer’s credit deteriorates and defaults. Nevertheless, in the event of company growth, preferred stock investors do not partake in the upside. The sole advantage for preferred stockholders is a higher cash yield compared to stock dividends, albeit generally less well compensated yield-wise than the debt above them.
An analysis of preferred stock funds, high-yield bond funds, and senior loan funds reveals that preferred stock funds have not matched the recent returns of credit investments, both in terms of distribution yield and total return. Given the lower total returns and the sacrifice of potential capital gains, some investors may opt for preferred stock funds in taxable portfolios to benefit from lower taxed qualified income.
In conclusion, while preferred stock may hold a place in an Income Factory portfolio, the trade-off between lower total returns and slightly higher distribution yields must be carefully evaluated. The nuanced considerations and implications of preferred stock make it an interesting topic for income investors looking to diversify their portfolios.
