A version of this post was submitted to Seeking Alpha.

 Summary

• Over the past 5 years, preferred stock funds have booked excellent risk adjusted performance relative to stocks and bonds
• Over the past 5 years, preferred stock funds provided significant diversification to stock and bond portfolios.
• Preferred stock funds have been generally less volatile than stocks and long term bonds.

 Preferred Stock CEFs

As a retiree, I am always looking for income opportunities that are relatively low risk.  Preferred stocks Closed End Funds (CEFs) are often overlooked by investors and have the potential for higher income than common stock funds.  Like common stocks, most preferred stocks bottomed in March of 2009 and recovered nicely until last June when the fear of rising rates precipitated another selloff.  However, as interest fears abated the preferred stock CEFs are again on the upswing.  Even with good performance, most of the CEFs are selling at substantial discounts to their Net Asset Value (NAV).  Does this represent a buying opportunity?  Only time will tell but if interest rates stay low, I like the prospects of preferred stock funds.  In this article I will update the analysis I performed last year and evaluate the risk and rewards associated these preferred funds.  For completeness, I will also include Exchange Traded Funds (ETFs) that focus on preferred stock.

Since some investors are not familiar with this type of asset, I will provide a quick review of how preferred stocks differ from the more familiar common stocks.  Many companies issue preferred stock since this is one way corporations can raise money without diluting the number of common shares. Preferred stock does not have voting rights but usually has a much higher dividend than common stock.  The dividend payment associated with preferred stock is not guaranteed but the preferred stock holder must be paid before the common stock holder can receive any dividends.  Thus, preferred stock sits between bonds and common stock in the capital structure.  It is senior to the common stock but will be paid after the interest on bonds. Suspending payments on preferred stock is a last resort but it is not considered a default like suspending payment to bondholders.  Issuing preferred stock is especially popular with financial institutions and many preferred stock funds have high concentrations of stocks in the financial sector.

After issuing a preferred stock, the price can fluctuate, with one of the key factors being interest rates.   If interest rates rise, then the price of the preferred shares will likely drop because investors will demand higher yields.  Also, like a bond, many of the preferred stock issues are callable at a specified date in the future.  The attraction of preferred stock is the high yield, with yields usually higher than high yield bonds, master limited partnerships, or dividend paying common stock.  However, there is no free lunch on Wall Street and the high yield comes with increased interest rate risk.

There are several closed end funds that invest primarily in preferred shares.  Using data from CEFConnect, I selected candidates based on the following criteria:

• At least 5 years of history (launch occurred prior to August, 2009)
• Distributions of at least 6%
• Must be selling at NAV or selling at a discount
• Market Cap had to be greater than $200M
• Average trading volume had to be greater than 100,000 shares per day.

The following CEFs satisfied all of these conditions:

Flaherty & Crumrine Preferred Securities Income (FFC).   This CEF has a distribution of 8.6% and sells for a discount of 3.6% (compared to a 52 week average discount of 0.5%).  The fund was launched 11 years ago and has a good long term track record.  Despite its high distribution, it has used return of capital (ROC) in only one year since inception.  The fund’s portfolio consists of 137 holdings, concentrated primarily in stocks of banks, insurance companies, and utilities.  It utilizes 35% leverage and has an expense ratio (including interest payments) of 1.6%.

John Hancock Premium Dividend Fund (PDT).   This John Hancock fund is more diversified than the pure preferred stock fund.  PDT consists of about 70% preferred stock and the rest is invested in dividend-paying equities.  It is selling at a discount of over 10% (which is about the same as than the average discount of 11%).  The fund has a distribution of 7.3%, none of which comes from ROC.   It has over 100 holdings, with the utility sector accounting for almost half of the total assets.   The fund uses 34% leverage and has an expense ratio of 1.8% (including interest payments).

Nuveen Preferred Income Opportunities (JPC).   This CEF sells at a discount of 12.4% (compared with the average discount of 10.9%) and has a distribution of 8.2%.  At the end of 2011, the fund changed its investment strategy from a multi-sector fund to a preferred stock fund.   Investors should be aware of this strategy change when evaluating this fund’s longer term performance.  The new strategy is generating sufficient income to cover distributions so the fund is not using ROC.  The fund has 287 holdings spread among insurance companies, banks, financials, and real estate investment trusts.  JPC utilizes 28% leverage and has an expense ratio of 1.7% (including interest payments).

Nuveen Quality Preferred Income (JTP).   This CEF sells at a discount of 10.3% (about the same as the average discount of 10.7%) and has a distribution of 7.5%.  It has over 200 holding, primarily in the insurance, commercial bank, and financial sectors.  It employs 29% leverage and has an expense ratio of 1.8%, including interest payments.  Another sister fund, Nuveen Quality Preferred Income 2 (JPS) has a similar portfolio that is highly correlated with JTP.  Therefore, JPS was not included in the analysis.

Preferred Stock ETFs

There are also a number of ETFs that focus on preferred stocks.  These funds differ from CEFs in that they passively track an index rather than being actively managed.  Also, the ETFs do not use leverage, so typically they are less volatile and have lower expenses than their CEF counterparts.  I included the three largest preferred stock ETFs in the analysis.  The ETFs selected were:

iShares S&P U.S. Preferred Stock Index (PFF).   This ETF is by far the largest Preferred Stock fund with over $9 billion in assets.  The index is composed of preferred stocks that have a market cap of at least $100 million, with almost 90% of the portfolio in stocks of financial institutions.  The portfolio holds 283 preferred stocks and has a low expense ratio of 0.47% and yields 6.7%.

PoweShares Preferred (PGX).  This ETF tracks the BofA Merrill Lynch Core Plus Fixed Rate Preferred Stock Index which required a market cap of at least $100 million.  As with PFF, almost 90% of the portfolio is invested in the preferred stock of financial institutions.  The fund holds 197 securities and has a 0.50% expense ratio and yields 6.2%.

PowerShares Financial Preferred (PGF).   Since most preferred stock are from financial institutions, the fact that this ETF focuses on financial preferred does not differentiate it from most of the other offerings.  This fund does limit its portfolio to only issues that pay qualified dividends so this fund is advantageous for taxable accounts.  The fund holds only 74 securities and has an expense ratio of 0.64%.  The fund yields 6.1%.

Reference

Since preferred stock has attributes of both bonds and stocks, I also included the following ETFs in the analysis for reference:

SPDR S&P 500 (SPY).   This ETF tracks the S&P 500 equity index and has a yield of 1.8% and an expense ratio of 0.09%.

iShares Barclays 20+ Year Treasury Bond (TLT ).  This ETF tracks the performance of long term treasury bonds.  It has an expense ratio of 0.15% and yields 3%.

Risk versus Reward 5 years

To compare the performances of these CEFs and ETFs, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility of each of the funds over the past 5 years (from August, 2009 to the present).  The Smartfolio 3 program was used to generate this plot that is shown in Figure 1.

Figure 1.  Risk versus reward over the past 5 years (click to expand)

The plot illustrates that the ETFs and CEFs have booked a wide range of returns and volatilities over the past 5 years.  To better assess the relative performance of these funds, I calculated the Sharpe Ratio.  The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with SPY. If an asset is above the line, it has a higher Sharpe Ratio than SPY. Conversely, if an asset is below the line, the reward-to-risk is worse than SPY.  Similarly, the blue line represents the Sharpe Ratio associated with TLT.

Some interesting observations are evident from the figure.

• As you might expect, with the exception of FFC, preferred stock funds had a lower volatility than the S&P 500.
• The preferred stock ETFs had the lowest volatility, even lower than long term bonds, (being lower than long term bonds was somewhat surprising).
• A few preferred stock CEFs (JPC, PDT, and FFC) had both absolute and risk adjusted returns better than the S&P 500.
• All the preferred stock funds handy outperformed long term bonds on both an absolute and risk-adjusted basis.
• Looking only at ETFs, PGX had the best risk-adjusted performance and PGF the worst.
• Looking only at CEFs, JPC had the best risk-adjusted performance with both PDT and FFC a close second and third.
• Over the past 5 years, preferred stock CEFs were excellent investments, with many besting the S&P 500.

Diversification

Since all the funds were invested in preferred stocks, I wanted to assess how much diversification you might receive by buying multiple funds.  To be diversified, you want to choose assets such that when some assets are down, others are up.  In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other.  I calculated the pair-wise correlations associated with the funds. I also added SPY and TLT assess the correlation of the funds with the S&P 500 and long terms bonds. The results are presented in Figure 2.  The results are enlightening.  First off, the preferred stock funds are not highly correlated with SPY and are negatively correlated with TLT.  This implies that you do receive substantial diversification effects by adding these funds to either a stock or bond portfolio.  Should you invest in more than one fund?  The ETFs are highly correlated with one another so I would only invest in one of these.  However, the CEFs are relatively uncorrelated with each other so adding more than one CEF would increase diversification.

Figure 2.  Correlation over the past 5 years (click to expand)

Risk versus Reward 3 years

I next looked at the past 3 year period to see if the outperformance continued.  The results are shown in Figure 3.  Over the past 3 years, the S&P 500 has been in a rip roaring bull market and has outpaced all the funds on an absolute basis.  However, all the preferred stock funds were less volatile than SPY and this allowed the preferred ETFs to book risk-adjusted performance about the same as the SPY.  The preferred CEFs had good performance over this period but lagged SPY and the ETFs on a risk-adjusted basis.  All the funds substantially outperformed long term bonds during this period.

Figure 3.  Risk versus reward over 3 years (click to expand)

The investment landscape became even murkier over the past year. To get a more near term view, I ran the analysis the over the past 12 months and the results are presented in Figure 4.  The SPY did well over this period but JPT had similar performance with less volatility.  The preferred ETFs all booked very low volatility and had risk-adjusted performance better than the S&P 500.  The results are less spectacular for the CEFs.  With the exception of JTP, all the CEFs had risk-adjusted performance that lagged both the ETFs and SPY.  TLT has had significantly better relative performance on a risk-adjusted basis, booking returns similar to JPC and FFC.

Figure 4.  Risk versus reward over past 12 months (click to expand)

Bottom Line

Which is better, the preferred stock ETFs or the CEFs?  As you have seen, it depends on the time period under analysis.  Over the longer term, CEFs generally had better risk-adjusted performance but over the last 12 months, the ETFs had a higher Sharpe Ratio.  So it really depends on the market conditions that you expect in the future.

Before leaving this analysis, there are a couple of additional factors that you should consider.  In addition to interest rate risk, preferred stocks also have a re-finance risk.  Since many preferred stocks are callable, the issuing company can call their preferred stock and re-issue at a lower interest rate.  This is especially true in a low interest rate environment like we have had recently.  In 2012, $13 billion of preferred stock was redeemed (with average coupon rate of 7.16%) and replaced with issues that had an average coupon rate of 6.37%.  This puts downward pressure on preferred prices.

Also, as part of the Dodd-Frank Act, non-perpetual preferred issues can no longer be used to satisfy Tier 1 capital requirements.  Tier 1 capital is a core asset held by banks and is a measure of financial strength used by bank regulators.  The banks must phase out the use of these preferred stocks by 2015 and replace them with other forms of capital.  One of the nuances of the Dodd-Frank Act is that it will likely allow some bank preferred trust issues to be recalled earlier than originally planned.  This increases the re-finance risk.

However, even with these headwinds, preferred CEFs and ETFs have been an excellent asset class over the past 5 years.  No one knows what the future will hold but if interest rates remain low, these funds should continue to perform well.  Historically they had produced good risk-adjusted returns and have added diversification to stock and bond portfolios.  Income investors should give these funds serious considerations.

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