Ignore the Banking Risk With Preferred Stocks

In just a few short weeks, the financial sector went from being as “safe as can be” to full-blown panic. After concerns about the now defunct Silicon Valley Bank’s (SVB) ability to meet depositor’s withdrawal caused a bank run and its failure, several other financial institutions came under fire and collapsed. Signature Bank also faced depositor runs and was closed by regulators over the course of a weekend, while Silvergate Bank voluntarily shut its doors to wind down its operations. This fury of activity culminated with the daring rescue of Credit Suisse by Swiss banking rival UBS (UBS).

And the issues have continued. First Republic (FRC) is now facing a similar fate as concerns about its ability to stay solvent have grown. The same could said for Western Alliance Bancorp (WAL)

While the crisis has continued, valuations for many of the banks have started to shrink to bargain levels. And truth be told, the vast bulk of banks are likely to come out of this situation unscathed. For investors looking to play the big bargains on the banks with less risk and generate some income, there is a play to be had in bank-preferred stocks.

Preferred stocks are considered a hybrid security – blending the attributes of equity and bonds into one. Just like bonds, these shares are issued at a certain amount called par value – usually $25 or $1,000 per share. They’re callable after a certain date for that par value. And like bonds, they pay a steady dividend payment to their shareholders at a fixed rate, usually in the 4% to 7% range.

But they also have attributes like stocks. They trade on exchanges, and because of market forces, preferred stock can trade at premiums or discounts to their par value. In terms of the capital stack, preferred stock outweighs common shareholders and are entitled to profits and dividends before common shareholders are able to get a penny. This includes suspended dividends that restart.

Banks are some of the biggest issuers of preferred stocks, covering about two-thirds of the $400 billion market. Utilities and REITs make up the bulk that’s left. The reason being is that banks are able to use preferred stock to raise capital and boost their reserve requirements without taking on additional debt. This makes regulators happy.

Thanks to the banking crisis, many bank-preferred shares are now trading for yields not seen in a decade or so. The sector benchmark, the ICE Exchange-Listed Fixed Rate Financial Preferred Securities Index, is paying close to 6%. But investors can score individual preferred shares with higher yields. For example, Morgan Stanley Series P shares are yielding closer to 6.4%, while Fifth Third Bancorp Series A shares are yielding closer to 7%.

Secondly, with that high yield comes very low default rates. According to Moody’s, from 1983 to 2016, the default rate for bank preferreds was only 0.5%. For other preferred sectors? The number is 2.3% over that time. In reality, most banks are flush with cash reserves. This should help them survive and thrive as the crisis moves to conclusion.

Another reason? Tax advantages. Those high yields often count as qualified dividends and count towards the 15% tax rate. Not many securities can offer such a high yield and that low of a tax rate.

Given their less risk, high tax-advantaged yields and historic low default rates, bank-preferred shares could make an ideal addition to an income portfolio. You certainly could research and buy them individually. However, that can be tricky. Institutional investors tend to buy & hold them for the long haul. Sometimes bid-ask spreads can be wide.

A better way could be within the ETFs and mutual funds. The $1.02 billion Invesco Financial Preferred ETF (PGF) tracks previously mentioned ICE index and holds 107 different bank-preferred stocks. With low expenses and a 6.4% yield, PGF could be the best fund to focus on the sector. The broader iShares Preferred and Income Securities ETF (PFF) is good as well, with about 70% of its holdings in banks. There are also numerous active mutual funds that cover the sector, allowing investors to take advantage of bargains.

In the end, the banking crisis is not something investors want to wtiness. But income investors may want to rejoice. They have an opportunity to pick up some yield and play the rebounding sector with banking-preferred stock.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.