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Profiting from Preferreds
We agree with Gregory Zuckerman and his article entitled, “Favorable Currents for Preferred Shares.” Preferred shares are a unique type of security that feature characteristics of both stocks and bonds. Like bonds, preferred shares are issued with a stated dividend coupon and a par value. Although preferred shares don’t have the same voting rights as common stock, they are higher up on a firm’s capital structure and their dividends must be paid out before a common stock’s dividend can be paid, providing them with more safety in the event a company runs into trouble. Preferred shares also have the benefit of trading like common stocks, both much easier and cheaper than trading bonds. The combination of attractive stock and bond features suggests that preferred securities are worth a serious look.
One of the appealing features that the article mentions about preferred securities as compared to common stock is the trading characteristics. Andrew Zimmerman, the chief investment strategist at DT Investment Partners LLC, was quoted as saying, “Preferred shares are slightly more like bonds than stocks as their historical price volatility more closely matches that of bonds.” The preferred securities’ high dividends and place on the capital structure help to act as a cushion against volatility and price swings when the market is confronted with economic shocks. This quality is particularly appealing to investors who are reluctant to invest in common stocks which many feel are due for a pull-back given their strong year to date gains.
Traditional preferred shares also have a favorable tax treatment that is typically only reserved for common stock dividends. The tax is much lower than that on corporate bond interest. Traditional preferred shares’ dividends are deemed, “qualified,” meaning they are taxed at the long term capital gains rate instead of the ordinary income tax rate applied to interest from corporate bonds. For those in the top tax bracket, the difference is between paying a 20% federal tax rate and 39.6%, respectively. As such, a corporate bond would have to yield 9.27% to keep pace with a traditional preferred’s dividend coupon of 7% on an after-tax basis. The preferential tax treatment of the preferreds compared to higher taxes and lower yields on corporate bonds makes preferreds a compelling choice.
Mr. Zuckerman appropriately noted however, that most preferred securities are perpetual in nature, and thus sensitive to interest rates. As such, when interest rates go up it is common for the prices on these securities to go down, the same reaction long term bonds would produce. While every investment has risks, a couple ways to partially mitigate the risk in preferreds is to find preferred securities from companies with improving fundamentals that are intent on redeeming their preferred shares. An improving credit profile may result in an increase in the price of the preferred share that may partially offset a resulting decrease in price from rising interest rates. Also, a company that is expected to redeem its preferred security will be less sensitive to interest rates similar to a short term bond. Another mitigating factor comes with preferreds that pay dividends over 7.5%. High dividend yields are somewhat insulated from interest rate moves.
Traditional preferred securities combine many of the favorable features of both bonds and stocks into a unique security: high dividend yield, favorable tax treatment, and lower historical volatility than common stock. Given these security characteristics and investors’ need for income in this historically low interest yield environment, preferred securities present a compelling choice, which explains why they are a core component of our Defensive Growth strategy.
Weekly Market Update – December 6, 2013
A stronger-than-expected November jobs report catapulted the Dow to a 199-point gain Friday, pushing the index above 16,000.
Friday’s job report showed 203,000 jobs added in November, above expectations of approximately 185,000. The number of jobs created in September were revised up to 175,000 from 163,000, though down for October (to 200,000 from 204,000). The unemployment rate fell from 7.3% to 7.0% (a five-year low), an encouraging number due to the fact that the decline was the result of more people finding jobs than leaving the workforce. The data released confirms the labor market is improving, though perhaps not robustly enough to launch the Fed into tapering action later this month. With inflation remaining a non-issue, it is thought the Fed will begin scaling back its stimulus program in March of next year. The Fed is scheduled to meet December 17-18.
Interest rates rose Friday with the yield on the 10-year Treasury rising 2 bps to settle at 2.88%.
Oil rose .3% Friday on the heels of the jobs report to close at $97.70, up 5.4% for the week, its biggest weekly gain since July. Natural gas settled .2% lower to $4.12, finishing the week up 4.0%. The cold weather invading the country should help boost the price of natural gas.
Next week, economic calendar highlights include weekly jobless claims and November retail sales on Thursday and November inflation data on Friday. Expect weekly jobless claims to settle in the 320,000 range (from 298,000 this week), retail sales to show an increase from October and inflation to remain in check.
Weekly Market Update – November 27, 2013
The Dow gained 25 points Wednesday on a relatively quiet day, closing at a record high of 16,097.
A spate of positive economic data was released today, including a better-than-expected weekly jobless claims number, a healthy manufacturing report and an upwardly revised consumer sentiment reading. However, the big-ticket report comes next Friday when the November jobs report is released. The result of the report will heavily factor into the Fed’s stimulus tapering strategy.
Interest rates rose Wednesday with the yield on the 10-year Treasury rising 3 bps to settle at 2.74%.
Next week, November new home sales on Wednesday, weekly jobless claims on Thursday and the aforementioned November jobs report on Friday highlight the week’s economic calendar. Expect November housing data to show an improvement from October, weekly jobless claims to settle in the 320,000 range (from 316,000 this week), the jobs report to show an increase in the number of jobs created from October (204,000) and the unemployment rate to remain at 7.3%.
Equity and bond markets and our office will be closed tomorrow, Thursday, November 28 for Thanksgiving. Our office will be open on Friday but equity and bond markets will close early, at noon and 1pm, respectively.
Weekly Market Update – November 22, 2013
Markets continued their upward trend Friday as the Dow gained 55 points on a relatively quiet day, ending the week up .6%. For the year the index is now up 22.6%.
Both the Dow and S&P 500 reached record highs Friday as comments from the Atlanta Fed President suggesting monetary policy will remain accommodative for many more years helped maintain the stock market’s bullish bias. Trading volume was light and is expected to be so through next week given the Thanksgiving holiday.
Interest rates fell Friday with the yield on the 10-year Treasury declining 3 bps to settle at 2.75%, up 4 bps for the week. This move helped preferred and trust preferred prices.
Oil fell .5% Friday to close at $94.83, down .4% for the week. Abundant oil inventories continue to keep oil prices lower. A possible reduction in sanctions currently levied against Iran in exchange for a more limited atomic program could result in a release of Iranian oil, further increasing supply and pressuring oil prices.
Next week, economic calendar highlights include October housing data and consumer confidence on Tuesday and weekly jobless claims and November manufacturing on Wednesday. Expect housing data to show an improvement from September, weekly jobless claims to settle in the 330,000 range (from 323,000 this week) and the manufacturing data to show a decrease in activity from October.
Equity markets and our offices will be closed next Thursday, November 28 for Thanksgiving but will be open on Friday.