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I recently got an email from a reader asking the following question.
I’ve read that you guys have been investing in Preferred Stocks. I went down a rabbit hole trying to understand them further (particularly Preferred Stock ETFs for broader diversification), but am still a bit perplexed.
I’m wondering if Preferred Stocks could have a place in a portfolio of early retirees, since we’re trying to live off our $ in 1.5 years and do need safer income-producing assets. Right now our portfolio is 100% equities (stocks and ETFs), but that seems too risky, so I’m looking to get to 25% in bonds/similar assets.
Would you be open to making a post on income producing assets that explains how Preferred Stock ETFs/Stocks vs Stocks vs Bond ETFs could fit into a recent retirees portfolio?
Which is a great question, because preferred shares are quite an interesting investment vehicle, and it’s not really that well understood, so let’s dive into this, shall we?
Preferred shares are a type of share that acts as a hybrid between a stock and a bond. They don’t give the owner voting rights like a common share would, so preferred shares don’t represent an ownership stake in the company the same way a normal stock would.
This means that preferred shares don’t fluctuate with the overall fortunes of the underlying company the same way a common share would. So the long-term performance of a preferred share is limited.
So why would anyone want to own these things? In a word, income.
Preferred shares are called “preferred” because if a company issues both preferred shares and common shares, dividends must be paid to the preferred shareholders first before their common shares. And preferred shares pay out dividends at rates higher than bonds, since preferred shares are riskier than bonds.
Another advantage is in their tax treatment. Bonds pay out their income as interest, which is taxed at your marginal rate. Preferred shares, on the other hand, pay out their income as qualified or eligible dividends. In the US, this means that they are taxed on the much lower dividend/long-term capital gains tax rates, with a married couple able to earn nearly $90k in qualified dividends without paying any taxes (assuming no other income is earned).
In Canada, dividends are eligible for the dividend tax credit, which offsets your tax bill to the point that a married couple can earn $110k in dividends and pay no taxes (again, assuming no other income is earned).
To ETF or not to ETF?
While I generally don’t recommend owning either stocks or bonds individually because of the much higher downside risk that comes from building a portfolio like this, I really really don’t recommend owning preferred directly.
Why? Because preferred shares are even more complicated to manage.
If you were to Google “Preferred Shares” and read some articles explaining how they work, you’ll come across a dizzying array of different features and options that can be associated with preferred shares. Some are cumulative, meaning that missed dividends will be paid back to you later, while others aren’t. Some have features that allow the shareholder to convert them to common stock. Some allow the issuer to call the share back under certain circumstances. And every preferred share has a different combination of rules that cause them to behave in weird and unpredictable ways.
We briefly tried to manage a basket of individual preferred shares way back in 2012, and let me say this: Never again. The overhead of dealing with all these different types of each share issue made this asset class the most work, by far, and after a few months of that we abandoned it for an index ETF and never looked back.
Preferred shares, like any other asset class, can be tracked with an index ETF. I highly recommend this, because this means that you don’t have to read through reams of data sheets for each individual share issue like you would if you built your portfolio directly. You just buy the ETF and you’re done.
Different Types of Preferred Share ETFs
One of the things that are simultaneously great and confusing about Preferred Shares is the fact that not all preferred shares behave the same way. Depending on how they’re issued, even preferred shares from the same company can behave in drastically different ways.
Fortunately, if you’re investing via an ETF, most of the complexity of preferred share is shielded from you. But you still have to be aware of the overall type of preferred you own, or you might be surprised if they move in a different direction that you’re thinking.
The 3 most popular types of preferred shares are:
Fixed Rate Perpetual
Fixed perpetual preferred shares are issued paying a fixed dividend rate, and that rate doesn’t change. In fact, the “perpetual” in these types of preferred shares indicates that this fixed rate doesn’t ever change, even at maturity, because quite simply, these types of preferred shares never mature.
This feature makes these types of preferred share act like more like bonds, which also pay a fixed rate that generally can’t be changed. That means that when interest rates rise, both bonds and fixed rate perpetual preferred shares will move in the same direction: down.
This is because when interest rates rise, that means new bonds (and preferred shares) will be issued paying a higher yield, so in order for these existing bonds (and preferred shares) to remain competitive, they have to sell at a cheaper price.
So the price of fixed rate perpetuals will move in the opposite direction of interest rates. If interest rates go up, fixed rate perpetuals will go down. And if interest rates drop, fixed rate perpetuals will go up, similar to bonds.
An example of a fixed rate preferred share ETF is the iShares Preferred and Income Securities ETF, PFF. You have to click into the fund’s facts sheet here, but if you do you’ll see that the fund is 70% fixed-rate issues.
Floating Rate
The opposite of a fixed interest rate is a floating interest rate.
As the name suggests, these preferred shares’ interest rate is expressed in terms of the current benchmark interest rate. So for example, one might be issued with a rate of “30-day Treasury rate + 2.5%” So if current rates change, the preferred shares’ interest rate gets updated right away.
This means that if interest rates rise, a floating rate preferred share ETF will go up in value, since their underlying shares will all start paying a higher interest rate, making them more valuable. Similarly, if interest rates drop, a floating rate preferred share ETF will go down in value, since the underlying shares will also drop their interest rates.
Notice how this is the exact opposite behaviour of fixed rate perpetuals. This means its really important to know what type of preferred share you’re investing in. Ever since I started investing in preferred shares, readers will occasionally email me saying “Hey, I bought preferred shares just like you, but mine are going down while yours are going up! What gives?” And when I click into the fund they give me, it turns out they bought the wrong one.
Always check the prospectus of any fund you’re looking into and make sure that it owns the type of preferred share that you actually want.
An example of a floating rate preferred share ETF is the Global X Variable Rate Preferred ETF, PFFV.
Rate Reset
And finally, there are rate resets. Rate resets are more popular in Canada for some reason, but basically these are issued with their rates relative to current interest rates, for example “5 year bond yield + 2.5%” Once they’re issued, their rates are fixed for a period of time, usually 5 years. And then at the end of that period, their rates reset (hence the name) to the new interest rate environment.
Rate resets are a little weird because they exhibit some behaviours of both fixed rate and floating rate preferred shares. Because their interest rates don’t change right away, when there’s an interest rate change, they will initially act like fixed rate perpetuals, falling when rates rise and rising when rates fall.
However, over time, as these preferred shares hit their reset dates, their payout rate also increases, which pulls up their value.
You can see this behaviour in the price history of the Preferred Share ETF we own, ZPR.
ZPR owns mostly rate reset shares, and you can see that as interest rates started to rapidly rise in 2022, ZPR tanked in value. We bought in early 2023, which saw a lot of continued volatility as everyone was guessing where interest rates would eventually end up, but it ended the year mostly flat. And in 2024, it’s been one of the best performers in our portfolio so far, with an impressive 6.5% gain in just the first 2 months of the year.
How they fit into a portfolio
So let me get this out of the way first. If you’re in the accumulation phase of your FIRE journey, you really don’t need to get into this asset class at all. Dividends can be taxed at 0%, but only if you’re in the lowest tax brackets. If you’re still working, odds are you aren’t in the lowest tax bracket, so your tax benefit from investing in these won’t be as good. Better to stick with an equity-heavy portfolio that gives their returns as capital gains, since you won’t be taxed on these at all until you sell.
After you’re retired, these may come in much more useful since you’ll a) need the income and b) be in a much lower tax bracket.
Preferred shares should generally, in my humble opinion, be treated as a fixed income asset rather than an equity. Remember, preferred shares don’t participate in the long-term uptrend that equities have, so if you replace your equity positions with preferred shares, you’re giving up a lot of future capital gains. Instead, I chose to replace my 25% bond allocation with them. This way, I’m just as heavily invested in equities as before (75%), but my fixed income portion is now paying way more (~6% vs ~3%).
This is how we gave ourselves a raise at the beginning of 2023, bringing my Yield Shield up from $45k to about $60k. In return, we accepted that our portfolio would be more volatile than before since preferred shares are more volatile than bonds, but we decided that this was a worthwhile trade-off. After all, once you’re Dividend FIRE, increasing income is more important than controlling volatility since I don’t need to sell anything to pay my bills.
Conclusion
So that’s our guide on investing with Preferred shares vs. bonds. What do you think? Would you consider adding these to your portfolio or are you more comfortable sticking with a tried-and-true stocks-and-bonds setup? Either way, let’s hear it in the comments below!
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This is brilliant, thank you! It answers questions I didn’t even know I had. Figured it wouldn’t be relevant until we actually pull the FIRE trigger, and going 75/25 VTI/preferred seems to make sense (seven years or so out, anyway). Pity Vanguard doesn’t offer any such ETFs… guess we’ve got a while to research things.
This is helpful, thank you.
How did your rebalance into preferred shares without it being a tax event?
I assume you did it in your tax advantaged accounts, but that also doesn’t make a lot of sense to me as I imagine you’d want that income in your after-tax accounts.
I’ll see if I can go back and see if you wrote about that previously, but rebalancing in tax advantaged accounts seems to be a challenge unless you’re using new money to buy the funds, or your selling at a relative equal cost basis?
Or I suppose you just eat the cost?
It’s called they paid income taxes on some of the capital gains in their non-registered account regarding adding ZPR into their portfolio. Of course it’s advantageous to hold them in the non-registered account (although, a smaller amount of ZPR can also be held in an RRSP/LIRA/RRIF, TFSA, FHSA as the fixed income component) as in Canada, you get the dividend tax credit for the dividends. In other words, pay $0 income tax for a bit more than $50k in Canadian dividends.
Ultimately, it’s ok to pay income taxes on your investment income and capital gains. You just do it in a way to minimize the pain. That’s all.
Yikes, now the movement of my preferred shares makes so much more sense! Thank you for that. I assumed (I know, lol) if the market went down, my preferred shares would go up. Didn’t occur to me that they were in fact tied to the interest rate. smh. But it’s all good. We’re working on a dividend portfolio and getting those monthly payments is FUN! 😀
preferred shares are one of the worst long term holds.( See their historical returns)
if seeking yield much better off with a SPY covered call etf. Will yield more AND return of capital will be significantly higher long term
“However, over time, as these preferred shares hit their reset dates, their payout rate also increases, which pulls up their value.”
So I also own ZPR and I’m wondering why this hasn’t happened yet in regards to their payout rate increasing? interest rates have increased significantly over the past 2 years and my understanding is that ZPR should have about 20% of it’s holdings reset in any given year yet the distribution has not increased one penny.
Any Idea why?
Thanks
Why is the yield of your preferred shares so much higher than a Dividend Aristocrat ETF like SDY?
Obviously your timing was great, but do you expect this to maintain its current yield over the long run? Why or why not? If not, will you revert back to bonds?
the 10 yr return of preferred share’s etfs is approx 1.5%. This includes its yield
‘timing the market’ , well…..:)
https://www.morningstar.com/etfs/xtse/cpd/performance
It gets worse actually. Try plugging ZPR into portfoliovisualizer.com. Any way you slice it, ZPR loses about half its value over a longer time period.
For example, if you had invested a portfolio of $1,000,000 in ZPR in the year 2000 and spent the yield along the way, you would have a portfolio worth only 640k in 2024. Compare that to a 20/80 portfolio of VGRO, and your $1,000,000 would have grown to over 1.4 Million today, even if you had spent the yield over the years.
If you had kept the dividends reinvested and simply sold off 40k worth of shares every year to fund your living expenses, then that Million-dollar ZPR portfolio would be worth only 541k today and VGRO would be worth over 1.3 Million.
Thank you!! Very informational !! When possible, I’d like to get your thoughts on “Close End Funds” and Covered Call ETFs as investment vehicles for generating income.
Yeah I don’t know about that. I owned PFF for 10 yrs and now I have to tell you, while preferred shares don’t participate in the long-term uptrend of the market, they do participate in the down-trend. I felt that pain during the pandemic and they don’t behave like bonds at all in these circumstances. Bonds went up in value while they were hammered, so not good at all for your diversification strategy.
Unless you really need income to pay you basic bills, I wouldn’t use them. Frank Vasquez agrees with me and laugh at this strategy, although it makes sense for a foreign investor, which he doesn’t know anything about…
Preferreds pay a high dividend because they are a loser in a crisis as the prior commentor noted.
If you divide your portfolio between growth and income, equity and fixed income, then obviously you want the growth portion to grow and the fixed income to not drop in value.
Why would you invest in fixed income that can decrease in value? Your stocks and fixed income will both go up and down. Where’s the diversification?
An additional thought is to ask what kinds of companies issue preferred stock? In the US companies can deduct interest cost on bonds against their taxes, but they pay dividends out of post-tax earnings. Why would a company borrow money and not get a tax deduction for it? Because paying the cost of borrowed money pre-tax would crater their earnings. Companies that issue preferred stock aren’t nice growing companies. Of course in good times the difference seems trivial, but in a major crisis when you really hope your safety belt works, it is more likely to fail, as noted above.
A portfolio strategy to consider is to buy stocks that raise their dividend each year by the inflation rate of more and the rest in cash, short term bonds or certificates of deposits.
Many companies raise their dividend annually and have for years. The shares increase in value as the company prospers. If the dividend increase drops below the inflation rate, it is probably time to sell.
If you have a 60/40 allocation, you need to sell stock in an up market and buy stock in a down market to keep your allocation 60/40. A huge crisis is the best time to add to your stock allocation so you want some cash for those once or twice in a decade bargain basement prices.
If you really need extra income, unless you are in the last years of your life, maybe you could explore other options; wait longer to retire, work part time, rent out a room, rein in spending for a year or two, etc.
This comment nails it. Preferred shares can’t replace bonds because the purpose of bonds is to sell and rebalance into equities when there is a downturn. In the next downturn if your preferred shares are down as well, then you will have nothing to sell and rebalance into equities. With preferred shares you are taking on huge risk with little reward, since they won’t give you the growth that broad-based equities give, and they won’t give you the rebalancing opportunity that bonds do.
i’m trying to wrap my head around Preferred Shares.
i see comments here about how Preferred shares doesn’t provide the “rebalancing effects” of bonds etc.
i think we have to read another blog entry from Wanderer about their decision to swap out their bond holding into Preferred shares.
https://www.millennial-revolution.com/invest/our-2023-portfolio/
If i understand correctly, OP reached a point where the dividends in their investment provides for the annual spending. So if the market tanks, they would not panic sell to cover their expenses. Yield Shielding it. No need to “rebalance”, but DividendFireCoastwhatever.
So since OP anticipates interest rates to go down, and preferred shares has dividend yield of about 6% ( 3% from Bonds ). Must as well their the higher one. Also, i don’t think this is a forever hold. More like a year by year decision. Mainly, that their asset allocation stays put for now ( US eq, CAN eq, EAFE, FIXED all equal at 25% )
I’m just summarizing ( poorly ) to help me understand better.
Totally agree, except with “wait longer to retire, work part time, rent out a room, rein in spending for a year or two, etc”. Most of us aren’t homeowners by choice.
If you need income, just sell shares. LT Cap gains tax rates are very favorable, and zero in most cases.
This make it easier to understand for folks especially as we review the portfolio for rebalancing and tax season. Preferred shares often go overlooked. PFF and other ETFs make it even easier. MSN Money used to have a great screener for this kind of stuff but it stopped working.
The article provides a comprehensive overview of preferred shares compared to stocks and bonds, particularly focusing on their role in a portfolio, their characteristics, and their suitability for different stages of the investor’s backpack battles journey, especially in the context of financial independence and early retirement.
Maybe Wanderer could publish the dates whenever they’re planning to buy/sell Preferred Shares so we all can “time the market” correctly, too ?
You ROCK Wanderer (and FireCracker too)!! Thanks so much for answering my question, and good to know that Preferred Share ETFs replaced your 25% income/bond allocation. I’m kind of curious now based on some other readers’ comments about how a Preferred Share ETF would compare to these S&P Covered Call ETFs. I’ll see if your reply to them.
A couple of follow up q’s: How consistent have your 6% dividends been with ZPR? And what do you think about other readers’ comments around how Preferred Stocks (ETF) tend to actually under-perform when bonds perform better (more like a stock/equity ETF)?
Grateful for you guys, can’t wait to hear more about your Mexico adventures with Little Matchstick.
Conceptual question on dividends here!
When you say a bond or preferred share pays a ~3% or ~6% dividend, what is that a percentage of?
For example – is it of the price you paid when you bought the bond or share?
Or, is it of the current value of the bond or share (in this case, the higher volatility of preferred shares makes less sense to me, as you may be earning a higher percentage, but of a lower stock value. Surely this isn’t the case, or is there some other upside I’m missing?)
Thank you!
Thanks, by far the more simple article I read about preferred shares. Now I understand the basics 🙂
Does Vanguard offer preferred shares?
good information with best values
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I find preferred shares interesting because they offer a balance between features of stocks and bonds. I think understanding the differences in voting rights, risk, and potential returns is important before investing. Even though it’s unrelated, Basketball Random reminds me that understanding the rules and mechanics can make a big difference in how you approach something. This was a helpful introduction to the topic.