Is There a ‘Preferred’ Solution for Fiscal Cliff Investing?

While markets struggled this year, preferred stocks trumped nearly every investment class.

President Barack Obama acknowledges House Speaker John Boehner of Ohio while speaking to reporters in the Roosevelt Room of the White House in Washington, Friday, Nov. 16, 2012, as he hosted a meeting of the bipartisan, bicameral leadership of Congress to discuss the deficit and economy.
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While markets struggled with uncertainty in a year set to end on a fiscal cliff, preferred stocks provided solid returns that topped nearly every other investment class—and some fund managers see more of the same in the year ahead.

So far this year, preferred stock has posted a total return of 18 percent, based on iShares Standard & Poor's U.S. Preferred Stock Index (PFF), the broadest listing of such shares. That compares with a 12 percent return for the S&P 500 (symbol: SPX) and 4 percent for the iShares Core U.S. Bond (AGG).

But rather than look at the past year, it might be more relevant to see what happened when the U.S. government last fell into a budget crisis that threatened the health of the economy. "If you go back to the debt-ceiling showdown [in 2011], the market got hit pretty hard during that eight-week period, and preferreds went down with it," says Chip Cobb, senior vice president at Bryn Mawr Trust, which manages $6 billion in assets. "But for the most part, it was a short-lived scenario."

Preferred stocks have posted a 9 percent-plus annual return over the past three budget-troubled years, as fiscal cliffs have become more or less the norm. That figure, based on the iShares Preferred index, suggests they might continue to provide above-average performance even in times of trouble.

[Read: How 3 Investing Pros Straddle the Fiscal Cliff.]

When to hunt bargains. Cobb says he remains cautious about buying shares of any description ahead of the cliff. But if stocks tumble over the cliff in the new year, he would start to look for bargains in preferred stock. "Something will get done. I would be shocked if nothing was done by January 15," he says.

Because their yields rise as prices fall, preferred-stock yields will go higher if their prices fall. Patient investors could be rewarded if they buy the shares selectively while the market is under siege and hold them. "I would do it in moderation—I would not back the truck up and load up with them."

Any sign of a compromise will likely spark a rally in a market that has been teetering on the brink since February. That's when Federal Reserve Chairman Ben Bernanke first warned of the year-end cliff faced by the U.S. economy when tax hikes and spending cuts are set to begin.

Even if a compromise is reached, there are worries about what kind of deal will emerge. After that, investors will inevitably get back to work assessing the long-term implications of the Great Compromise, if one is reached.

New year, new economy. Will it mean inflationary spending that weakens the dollar? Or will it bring higher taxes that slow the economy? Either way, preferred shares could hold up well, says Cobb. They trade in a relatively narrow range compared with other investment classes.

"In a rising-rate environment, there is less volatility in preferred stock," he says. And if the economy improves, companies have more cash to pay preferred dividends. While U.S. bond prices were the investment of choice during the last budget showdown, their rally has made them more expensive then ever.

"I would not go anywhere near government bonds at this point. Their yields are ridiculously low and they are very sensitive to interest-rate changes," says Cobb. "They are not worth it from a risk-reward viewpoint."

[Read: 3 Post-Election Tax Changes You Need to Know.]

The risk of preferred stock. Preferred stocks come with risks as well. The biggest issuers are banks, and they are under immense pressure to boost capital to shield against the kind of losses that hit in the 2007-2008 housing collapse. Pending bank reforms will limit the kinds of preferred stock that can be used for capital and may even force a wave of banks calling in existing preferred stock, meaning lost income to shareholders.

"Preferred securities have offered attractive yields recently, but that income comes with advantages and disadvantages," says Joanna Bewick, lead co-manager of Fidelity Strategic Dividend & Income Fund (FSDIX) in a Fidelity Viewpoints report.