FMD Capital Management

The Strategic Approach To Adding Preferred Stocks To Your Portfolio

Written by Michael Fabian, June 12th, 2013

Isn’t this what we have been waiting for? Doesn’t it feel great to finally see the high-yielding spectrum of financial assets give income investors a decent buying opportunity? Well I suppose that depends on which side of the table you currently sit at. From my perspective, the lack of volatility over the last several months created excesses, which led to complacency as a result of the slow monotonous grind higher. This was especially apparent in high yield bonds and preferred stocks.

Looking at the charts, cracks are emerging, and now is the time to perform all the due diligence you can so that you make informed portfolio management decisions. You should focus on areas with the largest dislocations that also coincide with your risk profile and goals. For clients of our firm, we are taking a close look at building a position in preferred stocks near the current levels. There are a few options in this space, but narrowing down our list, the two most likely candidates are the iShares Preferred Stock ETF (PFF), and the First Trust Preferred Securities and Income ETF (FPE). FPE is a fairly new fund and is actively managed, for those that aren’t familiar with the intricacies of an active vs. passive ETF, I wrote an article comparing the two.

At the time, I was waiting for a correction in preferred stocks, and it’s finally coming to fruition. Looking at a year to date chart of PFF, it has given back all the headway it has made in 2013.

However, that may not necessarily be enough to entice me to make a new investment at today’s levels. Although I don’t believe long term interest rates will climb much higher in the near term, the other side of the coin is stock market volatility. Preferred stocks have the unique feature of reacting to changes in both markets, and I don’t believe we are near an intermediate-term low in equities.

We strive to keep volatility as low as possible for our income clients, so our entry plan will include making small purchases strategically over time to establish an attractive cost basis. Preferred stocks have a history of falling hard and fast, then stabilizing, and finally recovering to the levels where the correction began. However, that type of behavior was naturally a result of the Federal Reserve’s accommodative QE policies. So the crux of the problem remains, how cheap is cheap-enough to begin adding to preferreds knowing that there may not be the open-ended commitment by the Fed that investors have become accustomed to?

Examining a longer term chart of PFF, in my opinion, preferreds wont present that type of value unless prices pull back at least another 3-7%.

That can always change, if the recent jaw-boning by the Fed is more reassuring. It purely depends on the chances of a change in tone, in addition to how much volatility you feel comfortable with in your portfolio. If the price of PFF did ultimately reach the 35.50-36.50 level, I think that would present immense value for long-term investors to lock in an income stream of over 5%. One thing to keep in mind though, is to not become over exposed. This can be psychologically taxing as you wait for stabilization if the purchase you make is bit on the early side. We target an allocation of anywhere between 0-15% in preferreds for a typical income portfolio.

Making opportunistic investments during sell-offs like this can feel like trying to catch a falling knife. It’s not easy, but keep in mind that volatility always has a way of subsiding, whether by pure price depreciation to a level that presents strong value, or by some sort of exogenous force like the Fed coming out of left field. Develop your game plan, adhere to it, and you will emerge from the most recent sell-off with a higher-yielding portfolio that can also take advantage of any future price appreciation.