Summary

• Since 2007, most preferred stock CEFs have outperformed the S&P 500 on a risk-adjusted basis.
• Preferred stock CEFs offer high income, with distributions typically over 7%.
• Preferred stock funds offer excellent diversification for both equity- and bond-focused portfolios.

As a retiree, I am always looking for income opportunities and I noticed that preferred stocks Closed End Funds (CEFs) have high distributions of 7% or more. However, risk is as important to me as income so this article analyzes the risk versus reward of these CEFs over several time periods.

Before I launch into the analysis, let’s take a quick review of the characteristics of preferred 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 the 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.

After a preferred stock is issued, the price can fluctuate, with one of the key factors being interest rates. Most preferred stocks are either perpetual or have maturities far into the future, which increases their sensitivity to rates. This was illustrated in 2013 when the fear of tapering caused discounts to widen and the price of these funds to drop.

In addition, some preferred stocks are callable so if interest rates fall, these preferred stocks may be called, creating a re-finance risk. This is especially true in a low interest rate environment like we have had recently. For example, 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.

Preferred stock is typically purchased because of its yield so if there is any hint that the preferred dividend may be suspended, the price of the preferred issue will likely plummet. This is usually not a large risk but it did happen in 2008. It could happen again in the current environment with the preferred stocks associated with energy companies, especially companies focused on oil shale resources. This is one of the reasons I would rather purchase a preferred CEF rather than individual issues.

For this analysis, I chose only funds that were in existence during the 2008 bear market so that I could judge performance during a recessionary period. I wanted to use relatively large funds so I required a market cap of at least $300 million. The following CEFs satisfied all of these conditions:

• Flaherty & Crumrine Preferred Securities Income (NYSE:FFC ). This CEF sells at a premium of 5.4%, which is higher than its 3-year average premium of 2.35. This fund typically sells at a premium but if you are patient you may be able to buy it at a discount. The portfolio consists of 134 holdings, concentrated primarily in the preferred stocks of banks, insurance companies, and utilities. All the holdings are U.S. based. The price of this fund dropped 45% during 2008 and 2% during 2013 (while the Net Asset Value increased 4%. The fund utilizes 33% leverage and has an expense ratio (including interest payments) of 1.6%. The distribution is 7.8%, paid from income with no Return of Capital (NYSE:ROC ).
• John Hancock (JH ) Preferred Income III (NYSE:HPS ). This CEF sells at a discount of 5.5%, which is larger than the 3-year average discount of 2.1%. The fund has 109 holdings focused mainly on utilities and banks, with about 95% being U.S. based. During the 2008 bear market, the price dropped 31% and during the 2013 pullback, the fund lost almost 10% in price (and 4% in NAV). It utilizes 34% leverage and has an expense ratio, including interest payments, of 1.7%. The distribution is 8%, paid from income with no ROC. Note that two additional preferred stock CEFs are in John Hancock family: JH Preferred Income (NYSE:HPI ) and JH Preferred Income II (HPF ). These sister funds have similar portfolios and are highly correlated with one another. Therefore, I only included HPS in my analysis since it was the most liquid.
• John Hancock Premium Dividend Fund (NYSE:PDT ). This CEF sells at a discount of 9.9%, which is larger than the 3-year average discount of 6.9%. The portfolio consists of 110 holdings with about 69% invested in preferred stock and the rest is in dividend-paying equities. All the holdings are domiciled in the U.S. and the fund is required by charter to have at least 25% of its portfolio invested in the utility sector. In 2008, the price of this fund dropped only 21%. In 2013, the price decreased by 6%, even though the NAV increased by 1%. The fund uses 33% leverage and has an expense ratio of 1.8% (including interest payments). The distribution is 7.6%, funded primarily from income but with a small ROC component.
• Nuveen Quality Preferred Income (NYSE:JTP ). This CEF sells at a discount of 7.6%, which is larger than the 3-year average discount of 6.4%. It has 204 holding with 90% in preferred stocks from primarily the insurance, commercial bank, and financial sectors. All of the holdings are domiciled in the U.S. In 2008, the fund lost 47% and in 2013, the price dropped 4% (while the NAV increased by 3%). The fund employs 28% leverage and has an expense ratio of 1.7%, including interest payments. The distribution is 7.7%, funded from income with no ROC. Another sister fund, Nuveen Quality Preferred Income 2 (NYSE:JPS ) has a similar portfolio that is highly correlated with JTP. Therefore, JPS was not included in the analysis.

There are also preferred stock Exchange Traded Funds (ETFs). These funds differ from CEFs in that they passively track an index. Also, the ETFs do not use leverage so typically they are less volatile and have lower expenses than their CEF counterparts. I included the largest preferred stock ETF in the analysis so I could compare the CEF performance with ETF performance. The ETF selected was:

• iShares U.S. Preferred Stock Index (NYSEARCA:PFF ). This is the largest preferred ETF and has a portfolio of 300 preferred stock that trade on the NYSE and NASDAQ. The majority of the holdings are from the financial sector. The fund lost 23% in 2008 and about 1% in 2013. The fund has a low expense ratio of 0.48% and yields 6.3%.

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 (NYSEARCA:SPY ). This ETF tracks the S&P 500 equity index and has a yield of 1.9%. For comparison, the S&P 500 lost 36% in 2008.
• iShares Barclays 20+ Year Treasury Bond (NYSEARCA:TLT ). This ETF tracks the performance of long-term treasury bonds. This asset class was one of the few winners in 2008, gaining over 33% (but lost 21% in 2009). The expense ratio is a low 0.15% and the yield is 2.7%.

To analyze risks and return, I used the Smartfolio 3 program over a complete bear-bull cycle (from 12 October 2007 to the present). The results are shown in Figure 1, which plots the rate of return in excess of the risk free rate of return (called Excess Mu on the charts) against the historical volatility.

Figure 1. Risk versus Reward over bear-bull cycle

As is evident from the figure, there was a relatively large range of returns and volatilities. For example, FFC had a high rate of return but also had a high volatility. Was the increased return worth the increased volatility? To answer this question, 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 apparent from Figure 1.

• The volatilities of the preferred CEFs was larger than the S&P 500. This was somewhat surprising since preferred stocks are less volatile than equities. However, the CEF structure typically increases volatility because of leverage and the ability to sell at discounts and premiums.
• Over the complete cycle, long-term bonds had the best risk-adjusted return. This is because bonds held up better than equities during the horrendous bear market of 2008.
• PDT had the best risk-adjusted performance among the preferred CEFs and JTP the worst.
• The performance of PFF lagged during this period.
• Overall, the preferred stock CEFs had good performance with most beating the S&P 500 on both an absolute and risk-adjusted basis.

Next I wanted to determine if the outperformance continued during an equity bull market so I reduced the look-back period to 3 years. During this period, several new CEFs were launched so I added the following to the analysis.

• Nuveen Preferred Income Opportunities (NYSE:JPC ). This CEF sells for a discount of 8.8%, which is larger than the 3-year average discount of 7.7%. At the end of 2011, the fund changed its investment strategy from a multi-sector fund to a preferred stock fund so I have included this CEF with the 3-year look-back period. The fund has 293 holdings with 86% in preferred stocks spread among insurance companies, banks, financials, and real estate investment trusts. The fund lost 1% in price during 2013 as the NAV increased 3%. All the holdings are from firms based in the U.S. The fund utilizes 29% leverage and has an expense ratio of 1.7% (including interest payments). The distribution is 8%, paid from income with no ROC.
• Cohen & Steers Select Preferred & Income (NYSE:PSF ). This CEF sells for a discount of 3.6%, which is about the same as the 3-year average discount. The fund holds 138 securities with almost all preferred stock, domiciled in the U.S. The fund utilizes 28% leverage and has an expense ratio of 1.6% including interest payments. The price of this fund stayed above water in 2013, with the price rising by 1% and the NAV increasing by 5%. The distribution is 7.8% funded mostly by income but with some ROC. This fund only trades an average of 30,000 shares per day so limit orders should be used if you buy or sell this fund.

The results of the 3-year analysis are shown in Figure 2. What a difference a few years made! Over the past 3 years, the SPY has been in a rip-roaring bull market and neither preferred stock CEFs nor the bond funds could keep pace.

Figure 2. Risk versus Reward over 3 years

The data shown in Figure 2 is more aligned with expectation, as the performance of the preferred stock CEFs was between that of bonds and equities. Also evident from the figure is that the preferred stock CEFs have relatively high volatility, about the same as the SPY. On the other hand, the preferred stock ETF had substantially lower volatility than equities or bonds and was able to book the best risk-adjusted performance (similar to SPY). Over this period, the new kids, JPC and PSF, led the pack with FFC close behind. HPF lagged but still had a performance similar to TLT. Over the past 3 years, the decision whether or not to invest in preferred stock CEFs was not as clear-cut as it was for the longer time period.

As a final run, I looked at data from the last 12 months when both preferred stocks and bonds were on a tear, both handily outperforming the S&P 500. During this period, HPF and PDT were the top performers but PSF, JTP, and FFC were not far behind. Over the last year, the CEFs have also been less volatile than SPY. PFF lagged in absolute return but because of its extremely low volatility, it had an excellent risk adjusted performance.

Figure 3. Risk versus Reward over past 12 months

One of the reasons touted for investing in preferred stock is diversification they provide. 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. So as a final analysis, I assess the degree of diversification by calculating the pair-wise correlations associated with the funds in my study. I used a 3-year look-back period and the results are shown in Figure 4.

Figure 4. Correlation matrix over the past 3 years

As is apparent from the matrix, preferred CEFs were relatively uncorrelated with the S&P 500 (with correlations between 25% than 50%). Preferred stocks were also uncorrelated with long-term bonds. Thus, the addition of preferred assets to an equity portfolio or a bond portfolio provided excellent diversification. The pair-wise correlations among the various preferred funds were also low, so you did not lose diversification benefits by purchasing multiple funds. Overall, preferred stocks lived up to their reputation for diversification.

Bottom Line

If interest rates remain low and the economy remains stable, preferred stocks funds should prosper. Preferred CEFs have always been volatile but in most years, the added risk has been rewarded by a commensurate gain, resulting in good risk-adjusted performance. If you are a risk-tolerant investor, preferred CEFs offer excellent diversification for an equity or bond portfolio. My favorites are PDT and PSF. If you want to minimize risk but still have exposure to this asset class, PFF is a good choice. No one knows what the future may hold but based on past history, preferred stock funds provided an income investor with a good total return at a reasonable risk.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More. ) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.