Learning To Love 5% Yields

FIVEPreferreds are the redheaded stepchildren of income investing. They just don?t get any respect, even though in these times of diminished rates of return on all but the lowest-rated junk bonds, failing to consider preferreds makes very little sense.

One knock on preferreds is that they are mostly below investment grade or ?junk rated.? This is correct, but it?s also misleading. Citigroup?s preferreds (CK, 27) are rated BB+ and yield about 6.3%, but its senior debt is rated A? and yields 4.5%. The ratings mainly tell you the securities? ranking in a bankruptcy, an event whose likelihood is more telling from the A? rating than the BB+. So, if you agree with me that Citigroup is a ?too big to fail? bank, why not collect the extra 180 basis points of yield on the preferreds over the bond yield? Think of the yield premium for preferreds not as a default-risk premium but as an ignorance premium.

Large institutions that manage billions in client assets avoid anything that is not investment grade despite knowing that the risk-reward ratio for such securities is in a client?s favor over investment-grade issues. The institution, however, is more concerned with protecting itself against lawsuits should a junk issue fail. It also wants to protect itself against rogue employees taking undue risks with client capital.

I once forced this issue with a brokerage firm that refused to execute preferred trades in below-investment-grade issues. It indicated it would relent if my client agreed to sign a letter saying they were sophisticated investors and knew they were buying a high-risk security. Talk about a good way to lose a client! This same firm had no problem allowing investment in a closed-end junk bond fund.

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