a few weeks ago I saw an article about mutual funds that invest primarily in preferred stocks. I can't find the article again. Anyone else see it?
Is it the one from the May 2 WSJ?:
(no mention of the possible effect on preferreds of the elimination of so-called "double taxation" on dividends)
>> Mutual-Fund Investors
Find 'Preferred' Play
By TOM LAURICELLA
Staff Reporter of THE WALL STREET JOURNAL
More mutual-fund investors are turning to a new solution to satisfy their thirst for income: closed-end funds investing in preferred securities.
Since last June, nine new closed-end funds investing in preferred securities have attracted $7.2 billion, more than 10 times the amount invested in similar funds over the previous eight years, according to Lipper Inc. Among the recent fund sponsors have been Nuveen Investment Management, Merrill Lynch Investment Managers and John Hancock Funds, and more launches are on the way.
But while closed-end funds and preferred stocks have each been around for a long time, the current group of offerings has a twist because these aren't your grandfather's preferred stocks. Traditional "preferreds" are a form of stock that pay fixed dividends. By contrast, this breed of preferreds -- sometimes called taxable or hybrid preferreds -- is considered debt.
As such, they yield more than traditional corporate bonds, sometimes as much as one percentage point in the current environment, but without the credit risk of high-yield, or junk, bonds. These securities are a corner of the fixed-income market that was created a decade ago but has only really taken off in the past several years.
"It's an asset class that hasn't been talked a lot about," says Bill Adams, who heads up product development for closed-end funds at Nuveen. "But it is a way to tap an asset class that offers attractive yields mainly from investment-grade companies."
For investors considering buying these or any bond funds right now, the outlook for interest rates is a pivotal near-term concern. Should interest rates rise, prices of preferred-securities funds will suffer like those of any fixed-income investment, and that could significantly erode the benefits provided by their high yields.
Still, the new portfolios are attractive right now because fund companies are packaging these preferreds in the form of closed-end funds, which can borrow money and invest it to substantially goose total yields above what investors could receive on traditional corporate bond funds. Closed-end funds differ from the more common format of open-end funds in that they issue a fixed number of shares that trade on stock exchanges. Depending on investor demand, closed-end fund shares can change hands at prices above or below the value of the underlying securities in the portfolio.
The borrowings, known as leverage, can help these funds produce yields three or four percentage points higher than open-end bond funds. And though their history is relatively brief, these preferred securities also have shown little correlation to other types of corporate bonds, government bonds or the stock market, which means they can be a helpful diversifier in a portfolio.
Of course, as with every investment, there are potential drawbacks to be weighed. For these preferred funds, it is the risk that interest rates will rise sharply. The same leverage that these funds use to boost returns can increase their volatility and magnify any losses if prices drop.
In addition, preferred securities carry longer-dated maturities, which means that should interest rates rise sharply, they will be more vulnerable to price declines than short-term debt. An investor needing to sell shares in this type of fund when rates are rising could suffer a loss on the initial investment.
But with few other options offering comparable yields, it is no wonder that investors are beating a path through this largely uncharted mutual-fund territory. And not surprisingly, fund companies are busy cooking up new preferred offerings to tap the investor interest.
Some of the expected offerings, like the forthcoming BlackRock Preferred Opportunity Trust II, are planning to invest mostly in preferred securities. Other firms are introducing portfolios such as the Nuveen Preferred & Convertible Income Fund 2 that pair preferreds with other types of securities such as convertible bonds. Meanwhile, Cohen & Steers, which has traditionally focused on real estate, recently hired away Merrill Lynch & Co.'s preferred analyst, William Scapell, and has registered with the Securities and Exchange Commission to launch a fund that invests in preferreds and real estate investment trusts.
Ten years ago, the market for these taxable preferred securities didn't even exist. They are essentially a hybrid creation that combines some features of preferred stock with corporate bonds. Virtually all of the issues are callable and their yield is higher than traditional corporate debt, in large part because they subordinate are to the issuer's other debt, which means that should the company get into financial trouble, holders of the preferred debt would get paid back after the owners of the traditional corporate debt. Today, a variety of different structures have developed even within the world of taxable preferreds as the market has grown to about $190 billion, double its size of five years ago.
The evolution of preferred funds has been unusual in that it has strictly been a closed-end phenomenon; there isn't a single open-end fund dedicated to investing in the asset class. (There are also still a few old closed-end preferred stock funds , which means investors need to check the prospectus carefully or ask their financial adviser to be sure of which type of fund they might be considering.)
The main reason for the closed-end format, fund companies say, is that the funds are mostly designed to produce maximum levels of income; price appreciation of the securities is only a secondary goal. On their own, the newer preferreds do offer higher yields than other types of corporate bonds, but it is the leverage provided by the closed-end funds that helps them attain their lofty yield levels. While it is technically possible for an open-end fund to use leverage, in practice it is extremely difficult.
Currently, preferred securities yield about 0.45 percentage point above traditional corporate debt and more than two percentage points above long-term Treasurys, according to Merrill Lynch. However, it is with the leverage in the closed-end format that the difference is most clearly evident.
According to Lipper, closed-end preferred funds launched over the past two years are yielding an average of 8.55%%. In contrast, the average open-end investment-grade corporate-bond fund is yielding 4.47% and the average general government-bond fund is yielding 3.88%. The average high-yield fund, investing in the debt of companies with lower credit ratings, is yielding 8.91.%
In addition to their higher yields, fund companies are promoting the preferred funds as good diversifiers to fixed-income portfolios. Indeed, the performance of preferreds in recent years has had a low correlation to traditional investment-grade bonds and even less of a match with high-yield bonds, according to data compiled by Merrill.
There has also been virtually no connection between preferreds and the stock market. "The performance of the underlying stocks don't tend to affect them too much," says Don Crumrine, chairman of Flaherty & Crumrine, which manages F&C/Claymore Preferred Securities Income Fund launched in January, in addition to two older funds.
Looking ahead, if inflation remains under control and interest rates rise only gradually as the economy recovers, improving credit quality ought to help offset some of the impact of rising rates for preferred-securities investors. Many funds also attempt to protect their portfolios from the impact of rising rates by hedging.
Unfortunately for investors, the track record of this new crop of preferred closed-end funds is far too short to judge how they will perform when the interest-rate winds turn against them. If rates were to rise sharply, however, they, like most types of long-term debt, would suffer.
"But you get a whole heck of a lot of current income on these funds," says Mr. Crumrine. "That tends to cushion whatever the principal decline an investor would suffer because of increasing rates." <<
online.wsj.com
(I don't know if this link will work -- I got to the article by searching for "preferred stock funds.") |
