Preferred-stock funds offered big income and returns last year, but don't expect a repeat

Economic Indicators Associated Press

Sometimes the middle road is the most exciting one.

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Both stock and bond mutual funds did well last year, but some of the best returns came from funds that sit somewhere in between the two markets. Preferred-stock funds invest in securities that are a hybrid of stocks and bonds, and last year they delivered more income than many bond funds and bigger total returns than many stock funds.

Just don't expect this year to be as good. Preferred securities still offer relatively big yields in a low-rate market in which savers are hungry for income, and fund managers say they expect another year of positive returns in 2015. But it's doubtful that the mix of conditions that swept preferred funds to returns of more than 10 percent last year can happen again.

A relatively small corner of the market, preferreds aren't what most investors imagine when they hear the word "stock." They generally pay a fixed amount of income, and yields can top 5 percent, which looks particularly attractive compared with the roughly 2 percent yield of a 10-year Treasury. Prices of preferreds also tend to be more stable than for common stock, which means they don't drop as much. But it likewise means that they lack the potential for big gains if the company's earnings take off.

WHAT WENT RIGHT LAST YEAR?

Like bond funds, the fortunes of preferred-stock funds swing with interest rates. When rates are falling, it's a boon because yields of existing preferred securities suddenly look more attractive, and their prices rise. That's what happened last year, when the yield on the 10-year Treasury sank from nearly 3 percent.

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The drop in rates helped preferred-stock mutual funds generate an average 11.4 percent return last year. The Standard & Poor's U.S. Preferred Stock index returned 14.1 percent.

They both topped the average return of the largest category of stock mutual funds, 11 percent, and of bond mutual funds, 5.2 percent. Investors have noticed and plugged a net $1.1 billion into preferred-stock mutual funds and ETFs during November, according to the latest data from Morningstar. That's a sizeable amount for a category that has $28 billion in total assets. But investors need to keep in mind that they carry risks as well.

WHAT ARE THE RISKS?

Atop the list of concerns is the threat that interest rates will rise, which would knock down the prices of preferreds. The economy is getting stronger, and the Federal Reserve is generally expected to hike short-term rates later this year for the first time since 2006.

Investors got a taste of the possible implications in 2013 during what's become known as the "taper tantrum." That was the period when the yield on the 10-year Treasury rose to roughly 3 percent, from less than 2 percent, on expectations that the Fed would wind down its bond-buying stimulus program. In June 2013, when the tantrum was close to its height, preferred-stock mutual funds lost an average 2.6 percent. They lost another 2.5 percent in August 2013.

Another risk for anyone buying preferreds is that nearly all of them are issued by the financial sector. Close to 90 percent of the S&P U.S. Preferred Stock index comes from banks, insurance companies and other financials. A smattering of utilities and companies from other sectors round out the market.

Defaults can also be a concern. A bank's preferred stock generally carries a weaker credit rating than its bonds.

WHY DO MANAGERS STILL EXPECT GAINS?

Some fund managers expect long-term interest rates to rise only a modest amount this year. Phil Jacoby, for example, says the yield on the 10-year Treasury could end the year around 2 percent, close to where it is today, or even dip as low as 1.5 percent. He is one of the managers of the Principal Preferred Securities fund, the category's largest mutual fund.

A strengthening U.S. economy seems like it should be driving rates higher, but weakening economies elsewhere in the world and the plunging price of crude oil are exerting pressure in the opposite direction. That helped push the yield on the 10-year Treasury down to 1.94 percent this past week after ending 2014 at 2.18 percent.

If Treasury rates stay close to where they are -- and if preferreds continue to offer yields that are several percentage points higher than Treasurys -- investors could expect their total returns at least to include the payments made by their preferred-stock funds.

Other managers are moving into areas of the preferred market that can offer better interest-rate protection. At the Nuveen Preferred Securities fund, for example, portfolio manager Douglas Baker has bought preferred securities whose payment rates have the potential to adjust higher in the future.

He also says investors have been overly skeptical of the preferred market due to its concentration in financials. Since the financial crisis, banks have had to strengthen their balance sheets and cut back on riskier businesses due to new regulations. That means they're less at risk of a default.