Is There a 'Preferred' Solution for Fiscal Cliff Investing?

While markets struggled with uncertainty in a year set to end on a fiscal cliff, preferred stocks provided solid returns that topped nearly every other investment class--and some fund managers see more of the same in the year ahead.

So far this year, preferred stock has posted a total return of 18 percent, based on iShares Standard & Poor's U.S. Preferred Stock Index (PFF), the broadest listing of such shares. That compares with a 12 percent return for the S&P 500 (symbol:SPX) and 4 percent for the iShares Core U.S. Bond (AGG).

But rather than look at the past year, it might be more relevant to see what happened when the U.S. government last fell into a budget crisis that threatened the health of the economy. "If you go back to the debt-ceiling showdown [in 2011], the market got hit pretty hard during that eight-week period, and preferreds went down with it," says Chip Cobb, senior vice president at Bryn Mawr Trust, which manages $6 billion in assets. "But for the most part, it was a short-lived scenario."

Preferred stocks have posted a 9 percent-plus annual return over the past three budget-troubled years, as fiscal cliffs have become more or less the norm. That figure, based on the iShares Preferred index, suggests they might continue to provide above-average performance even in times of trouble.

[Read: How 3 Investing Pros Straddle the Fiscal Cliff.]

When to hunt bargains. Cobb says he remains cautious about buying shares of any description ahead of the cliff. But if stocks tumble over the cliff in the new year, he would start to look for bargains in preferred stock. "Something will get done. I would be shocked if nothing was done by January 15," he says.

Because their yields rise as prices fall, preferred-stock yields will go higher if their prices fall. Patient investors could be rewarded if they buy the shares selectively while the market is under siege and hold them. "I would do it in moderation--I would not back the truck up and load up with them."

Any sign of a compromise will likely spark a rally in a market that has been teetering on the brink since February. That's when Federal Reserve Chairman Ben Bernanke first warned of the year-end cliff faced by the U.S. economy when tax hikes and spending cuts are set to begin.

Even if a compromise is reached, there are worries about what kind of deal will emerge. After that, investors will inevitably get back to work assessing the long-term implications of the Great Compromise, if one is reached.

New year, new economy. Will it mean inflationary spending that weakens the dollar? Or will it bring higher taxes that slow the economy? Either way, preferred shares could hold up well, says Cobb. They trade in a relatively narrow range compared with other investment classes.

"In a rising-rate environment, there is less volatility in preferred stock," he says. And if the economy improves, companies have more cash to pay preferred dividends. While U.S. bond prices were the investment of choice during the last budget showdown, their rally has made them more expensive then ever.

"I would not go anywhere near government bonds at this point. Their yields are ridiculously low and they are very sensitive to interest-rate changes," says Cobb. "They are not worth it from a risk-reward viewpoint."

[Read: 3 Post-Election Tax Changes You Need to Know.]

The risk of preferred stock. Preferred stocks come with risks as well. The biggest issuers are banks, and they are under immense pressure to boost capital to shield against the kind of losses that hit in the 2007-2008 housing collapse. Pending bank reforms will limit the kinds of preferred stock that can be used for capital and may even force a wave of banks calling in existing preferred stock, meaning lost income to shareholders.

"Preferred securities have offered attractive yields recently, but that income comes with advantages and disadvantages," says Joanna Bewick, lead co-manager of Fidelity Strategic Dividend & Income Fund (FSDIX) in a Fidelity Viewpoints report.

Still, she says she considers them "a core holding in our non-bond income strategy" and lists them high among the "creative ways of finding income."

The emphasis on creativity is important, though, since it takes some research and investing savvy to sort through preferred shares offerings. It's complicated because preferred stock is a broad term given to a wide variety of interest-paying shares issued by companies. They include convertibles and trust shares, for example, that have much different tax advantages. Some guarantee cumulative payments, and some pay monthly. The devilish details can be tricky to decipher.

Regardless, investors have been stuffing cash into higher-paying preferred stock funds and individual shares at record levels as they move to one of the last good options for decent yield.

Preferred stock funds vs. individual stocks. By investing in funds, they spread out the risk of non-payment by a single issuer, which is two to three times as likely as it is with bonds since companies can opt not to pay dividends.

[See: The 10 Most Popular Mutual Funds of 2012.]

But the downside of investing in funds is that their payments tend to reflect the prevailing market rates, since they must continuously reinvest in the market to maintain liquidity. Cobb says he prefers to lock in yield as he can with individual shares. That is the one thing to consider in buying the securities, he says. "Capital appreciation is secondary. Preferred stock is all about income," he says.

With a fiscal cliff on the horizon, preferred stock is also about being nimble. Senate Majority Leader Harry Reid's warning on Thursday that Congress is not likely to have a deal before January 1 set off a new selloff. For investors, the new year is fraught with uncertainty.

"I would err on side of caution if I was deploying money today," he says. "I am putting in less today than I would be if this fiscal cliff was not looming. I am no fan of anybody in either party in Washington at this point."

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