Income Investors Look Out: Why Preferred Shares Can Be Risky Investments Today

It’s tough to find a decent yield today with central banks around the world forcibly keeping rates low. Investors are starting to get more creative and more aggressive. One place that I’ve seen brought up frequently in the comments of my articles is preferred shares. That’s not a bad option, but you have to be just as careful about prices and valuation as you would anywhere else today. Here’s an example.

Low yield

Public Storage Ltd (NYSE:PSA) is one of the largest self storage real estate investment trusts, or REITs, around. It has a history of offering up fairly modest yields, focusing more on growth than distributions. For example, during the depths of the 2007 to 2009 recession the yield on Public Storage’s shares only got to around 5% or so. Compare that to Realty Income (NYSE:O), where the yield spiked to around 10%.

Today, Public Storage’s shares yield 3.1% or so. Interestingly Realty Income yields 3.6%, not a whole lot more. That speaks volumes about the demand for safe yield. But, at the end of the day, it’s hard to call 3% an exciting yield, particularly when you can buy a stock like Coca-Cola (NYSE:KO) with a yield of around 3.2%. But when it comes to Public Storage, there’s another option. The company also has a long history of using preferred shares to raise capital.

Preferred shares are an interesting asset class. They are higher up on the capital structure than common stock and lower than bonds, so in some ways they are safer than stocks and riskier than bonds. Moreover, they trade like stocks, but can generally be redeemed by the issuer at their par value, like a bond. Dividends, meanwhile, are based on that par value, also like a bond. They are an odd hybrid.

Some key takeaways from all of this: Because they are issued with a par value and can usually be bought back by the issuer at that price, you pretty much know what they are worth. Some preferred have mandatory redemption dates, so you know when they will be bought back, and others just give the issuer the right, but not the obligation, to buy them back at par after some specified time. But because they trade like stocks with supply and demand determining their price, they can trade above and below their par value.

Because of their bond like qualities, preferred shares generally have higher yields than you would find in the issuing company’s stock. So, for an investor in search of income today, shifting into a preferred stock seemingly makes a lot of sense-higher yield, higher up on the capital structure, and some similarity to bonds. But you already know there’s more going on, so don’t jump just yet.

The “X” factor

To help highlight some risks in the preferred space, take a look at Public Storage Ltd 5.20% Dep Shares Cumulative Preferred Stock Series X (PSA-X). This preferred has a par value of $25. It pays $1.30 a year in dividends, or $0.325 a quarter, equating to a 5.2% yield based on the $25 par value. So far so good, and if you like Public Storage but want a little more yield, you might be interested in this security.

But it trades based on supply and demand. PSA-X was recently priced at around $26.20 a preferred share. That trims the yield to around 5%. That’s not a huge difference in the grand scheme of things, and perhaps you’d be happy with a 5% yield compared to the 2% or so being offered up by the broader market.

Here’s the thing, you know that PSA-X is worth $25. You are paying nearly 5% more than that price if you buy it at recent levels. In other words, unless you sell PSA-X to someone at a higher price than what you paid, you are locking in a 5% loss on this investment when it gets called. That’s roughly a year’s worth of dividends. The big picture from this… if you pay above par for a preferred you need to pay attention to this detail and, more important, be OK with it.

Which brings up another little wrinkle with preferred shares, they do actually get bought back by the issuer. There’s various ways this can happen, from mandatory redemptions to optional ones. As noted, some preferred shares have protected periods during which they can’t be redeemed. That’s the situation at PSA-X, which can be redeemed at any point after March 13, 2018.

Step back and think about that. If you buy PSA-X today you can expect to get six dividend payments before the redemption date. If you hold through redemption you’ll also get a partial dividend for the period between January 1, 2018 and the day it gets redeemed. Just to make things easy, let’s call that seven dividend payments. But if you pay $26.20 and the shares get redeemed at $25, then you are giving up the equivalent of four dividend payments in the capital loss you’ll face. So you’ll only really get three dividend payments… PSA-X should start to sound like a less attractive deal.

A grain of salt

That said, PSA-X may not get called at that point. But at whatever point it does get called, you’ll still face that capital loss if you buy it today. And if rates do indeed stay lower for longer, there’s good reason to believe that PSA-X could be called with Public Storage simply selling a new, lower yielding preferred to replace it.

If you are looking to the preferred market in search of yield you need to tread carefully. There’s more going on than there seems and the risks you face grow if you are paying above par value for a preferred. PSA-X is just one example. In other words, even in the preferred world, you need to take price/valuation into consideration. And today valuation is, perhaps, the biggest risk you face in the markets.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Unique Finance). I have no business relationship with any company whose stock is mentioned in this article.