Preferred Stock Mutual Funds: A Strategic Income Investment

As a fixed income specialist who has analyzed preferred securities for over a decade, I can attest that preferred stock mutual funds occupy a unique middle ground between bonds and common stocks. These hybrid instruments offer compelling benefits but come with specialized risks that demand careful consideration.

Understanding Preferred Stock Funds

What Preferred Stocks Offer

• Higher yields than common stocks (typically 5-7% currently)
• Priority over common shares in dividends and liquidation
• Potential for price appreciation (unlike bonds)
• Tax advantages (qualified dividend treatment)

How Funds Structure Their Holdings

Fund Type	Typical Portfolio Composition	Yield Focus
Pure Preferred	80-100% preferreds	Highest income
Hybrid Preferred	50-80% preferreds + bonds	Balanced
Convertible Preferred	30-50% convertibles	Growth/income

Top-Performing Preferred Stock Funds (2024)

Fund Name	Ticker	Yield	Expense Ratio	5-Yr Annualized
Cohen & Steers Preferred Secs	CPXAX	6.2%	0.97%	4.8%
Nuveen Preferred Secs	NPRAX	5.8%	0.85%	4.2%
Principal Preferred Secs	PPIAX	5.5%	0.85%	3.9%
John Hancock Preferred Inc	HPI	6.0%	0.85%	4.5%

Data as of June 2024; yields net of fees

Key Advantages of Preferred Funds

1. Attractive Current Income

• Average yield 200bps+ above investment grade bonds
• Qualified dividend treatment (15-20% tax rate)

1. Lower Volatility Than Common Stocks

• 20-30% less price fluctuation than S&P 500
• Limited upside/downside compared to commons

1. Diversification Benefits

• Correlation of 0.4-0.6 with both stocks and bonds
• Performs well during rising rate environments

Critical Risks to Consider

Interest Rate Sensitivity

Preferreds behave like long-duration bonds when rates rise:

Price\ Change ≈ -Duration \times \Delta Yield

Example: A preferred with 7-year duration falls ~7% if rates rise 1%

Credit Risk Concentrations

• Financials issue 65-75% of preferreds
• Energy/utilities another 15-20%
• Minimal industrial exposure

Call Risk

• Most preferreds are callable after 5 years
• Funds constantly reinvest called securities

Comparative Analysis

Metric	Preferred Funds	Bond Funds	Dividend Stock Funds
Current Yield	5-7%	3-5%	2-4%
Volatility	8-12%	4-8%	14-18%
Rate Sensitivity	High	Moderate	Low
Credit Risk	Medium	Low-Medium	High

Tax Considerations

1. Qualified Dividend Income

• Most preferred dividends qualify for 15-20% rates
• 199A deduction may apply for pass-through entities

1. Return of Capital Risk

• Some distributions may be classified as ROC
• Reduces cost basis (creates future tax liability)

1. AMT Exposure

• Certain preferreds may trigger AMT
• Funds must disclose AMT liability

Who Should Invest?

Ideal Candidates

• Retirees seeking higher yield
• Taxable accounts benefiting from qualified dividends
• Balanced portfolios needing hybrid exposure

Poor Fits

• Growth-oriented investors
• Those in highest tax brackets (consider munis)
• Risk-averse bond investors

Portfolio Allocation Guidance

Investor Profile	Suggested Allocation
Conservative	5-10% of fixed income
Moderate	10-15% of income allocation
Aggressive	Up to 20% of income holdings

Selecting the Right Fund

1. Check Credit Quality

• Minimum 70% investment grade (BBB- or higher)

1. Review Rate Hedging

• Look for funds using interest rate swaps

1. Analyze Sector Weightings

• Avoid >40% concentration in any sector

1. Compare After-Tax Returns

• Municipal bond funds may be better for high-tax investors

The Bottom Line

Preferred stock mutual funds offer a compelling yield advantage in today’s income-starved environment, but require active management to navigate their unique risks. As I advise clients: “Think of preferreds as the convertible bonds of the equity world – they pay like debt but can surprise you with equity-like behavior when markets turn volatile.” For suitable investors, allocating 10-15% of fixed income holdings to a well-managed preferred fund can enhance yield without dramatically increasing portfolio risk.