Milwaukee, Wisconsin – Investors seeking stable double-digit yields are eyeing high yield preferreds as an opportunity to capture potentially lucrative returns. Among these investments are Chimera Investment Corporation’s preferreds, offering over 11% yield with moderate risk. However, caution is warranted as there are risks lurking in the realm of high yield preferreds that investors must carefully navigate to separate the promising from the perilous.
Preferred investments offer three primary ways for investors to earn returns: dividends, liquidation preference, and redemption. Despite similarities to bonds, preferreds hold a slightly riskier position in the capital stack, sitting below debt but above common stock. This structure can lead to challenges as preferred dividends do not trigger an event of default like missed bond interest payments, making them a lower priority for companies. In exchange for these risks, preferreds typically offer higher yields than bonds, with the spread between the two reflecting the additional risk preferred holders take on.
Investors must assess various factors, such as equity cushion, business volatility, premium to par, and the potential for bad actor risks, to determine the appropriate yield for a preferred investment relative to its current trading price. Companies with strong balance sheets and well-managed operations should trade at a narrower spread to bonds than those with weaker financial positions. However, discrepancies in the market’s assessment of risk can present both dangers and opportunities for investors.
Presidio Property Trust, Inc.’s preferred shares, for example, may appear attractive with a high current yield and significant upside potential. Still, the lack of sufficient equity backing raises concerns about the potential for common equity to be wiped out, affecting the preferred shares. Similarly, volatile businesses like hotels can pose risks for preferred investors, as demonstrated by Sunstone Hotel Investors, Inc.’s preferreds trading at insufficient yields to compensate for the sector’s cyclical nature.
In addition to business volatility, bad actor risks can undermine the value of preferred investments. Management decisions or deceptive practices can negatively impact a preferred’s value, as seen in instances where promised conversion rates were not honored or when assets were removed from underneath preferred shares. Investors must exercise caution, especially in high leverage situations within volatile sectors, to mitigate these risks effectively.
Even preferreds from stable, highly profitable companies like Prologis, Inc. carry unique risks, such as redemption risk that could erode returns over time. Despite strong fundamentals, market pricing may not always reflect the potential dangers associated with preferred shares. As the market focuses on current yields, it may overlook future redemption risks, leading to unexpected capital losses for investors.
As the landscape of high yield preferreds presents a mix of opportunities and pitfalls, prudent single-issue selection and thorough research remain essential for investors to navigate this market successfully. By understanding the nuances of preferred investments and discerning between advantageous prospects and potential traps, investors can make informed decisions to optimize their portfolios.
