Preferred stock is a form of equity offering relatively high dividend payments compared to those available from common stock. The dividends on preferred stock compete directly with bond interest for investors seeking steady income. If interest rates rise, the value of competing preferred shares will decrease due to their relatively lower yields. This is interest rate risk, and you can hedge it using a combination of portfolio selection and active hedging with derivatives.
Hedging With Derivatives
Derivatives are financial instruments or contracts that derive their value from an underlying asset or index. If you fear that interest rates will rise, you can trade a derivative that increases in value with interest rates. For example, interest rate futures are contracts that are tied to the price of interest-bearing instruments, like bonds. If you sell interest rate futures, you benefit from lower bond prices that result from higher interest rates. You can also buy a financial futures contract that appreciates directly with an interest rate index, such as the London Interbank Offer Rate, or LIBOR. You can consider other exotic derivatives, such as options on futures and interest rate swaps, but they are usually traded by sophisticated investors.
You can lower your interest rate risk by diversifying your preference stock portfolio among perpetual and maturing issues. Perpetual preference shares have no maturity date and are fully subject to interest rate risk. However, preference shares with maturity dates from five to 25 years are increasingly popular. Those with shorter maturity dates are less exposed to interest rate risk because they are redeemed at a preset price. By increasing your investment in short-maturity preferreds, you can limit interest rate risk and still earn high dividend income.
A putable preferred stock trades with an embedded put option, giving the investor the right to sell the stock back to the issuer for a preset price. By seeking out preferred shares with this feature, you protect against higher interest rates that drive down the prices of regular preferred shares. The put option ensures that you can redeem your shares for a known price that is not affected by interest rates. Because of this benefit, putable preferred shares tend to have slightly lower yields.
Floating Rate Shares
Some preferred shares are issued with floating dividend rates. As interest rates rise, the share issuer will raise the dividend rate on the preferred stock. The prices of such shares remain stable because their dividend yields keep pace with interest rates. This can work against you, however, if interest rates fall. Some investors allocate a fraction of their holdings to floating rate shares for downside protection while allowing their fixed-rate shares to provide them upside potential.
Most, but not all, preferred shares are issued with embedded call options that give the issuer the right to forcibly redeem the shares for a preset price. Issuers will exercise this right if interest rates fall, because they can issue new preferred shares with a lower dividend yield. Any price appreciation you enjoyed due to falling interest rates will be lost if the shares are called, so a prudent investor might seek out non-callable shares for at least part of a portfolio.
Video of the Day
- Preferred Stock Investing; Doug K. Le Du
- Investing in Preferred Stock: An Introduction for Modern Income Investors (2nd Edition); Paul Josephs
- Preferred Stocks: The Art of Profitable Income Investing; Ken Winans, John Maybury
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