A Preferred Play to Bet on Risk

A Preferred Play to Bet on Risk

By BOB TITA

Preferred securities can provide investors with an appealing combination of high risk-type returns from low-risk companies.

"We like the idea of investing in a double-A rated bank or financial services company and getting a return that matches a lower credit profile," said Douglas Baker, manager of Nuveen Investments LLC's Nuveen Preferred Securities Fund (NPSAX) "We're able to move down the credit structure to get a compelling return for our investors."

.Preferred securities, which include shares of preferred stock and shares of preferred trusts, often are rated three to five notches below a company's overall credit rating to reflect their lower place in the pecking order of secured debt in the event of a default. As a result, preferred securities typically pay higher dividends or interest than senior and subordinate-level corporate bonds.

The Nuveen fund, which has assets of about $680 million, is yielding 6.46%, according to research firm Morningstar Inc. A 10-year U.S. Treasury bond earns about 3.5%, while the Barclays Capital U.S. corporate bond index yields 4.1%.

To offset some of the risk of owning assets that are less secure, Mr. Baker has loaded the Nuveen fund with securities for blue-chip companies, mostly banks, financial-services concerns and insurers.

Banks are among the most frequent issuers of preferred securities because regulators count them toward banks' capital requirements and a large portion of the interest paid on the securities is tax deductible.

J.P. Morgan Chase & Co., Wells Fargo & Co. and German insurer Allianz SE are among the Nuveen fund's top five holdings, which account for 17.6% of the fund's total assets.

The fund's high concentration of bank stocks was a big factor in its dismal performance initially. Coming out of the gate in 2007, it had a loss of 10.1% and followed that up with a loss of 24.7% in 2008, as the banking industry unraveled under the weight of the credit crisis and bank failures.

Mr. Baker, who worked for Lehman Brothers Holdings before joining Nuveen in 2006, credits the U.S. government-sponsored bank bailout for pulling the industry out of its nosedive and restoring banks' confidence in lending.

"It's caused a pretty meaningful snap-back in the financial services sector," he said about the Troubled Asset Relief Program, or TARP. "Through 2010 we continued to benefit from a greater tailwind than other sectors of the economy."

In 2009, the Nuveen fund posted a return of 43% and last year it returned nearly 19%, according to Morningstar. Meanwhile, the benchmark Barclays Capital U.S. Aggregate Bond Index had a return of 5.9% and 6.5% in 2009 and 2010, respectively.

This year, the fund is up 2.5%, or 2.2 percentage points above the benchmark bond index. The Nuveen fund's performance is keeping it near the top of the long-term bond category, after finishing in the second percentile in 2010.

Besides the recovery in the banking and financial-services sector, Mr. Baker attributes the fund's strong performance to a limited number of similar funds focused on preferred securities and low levels of investment in the asset class by hedge funds and other institutional investors. That has reduced the Nuveen fund's competition for bargain-price assets and other investing opportunities.

Preferred securities "have really flown under the radar. It's not as well-known as regular common stock or bonds," said Mr. Baker, adding that concerns about insufficient liquidity in preferred securities have kept away high-volume institutional traders.

Nuveen, of Chicago, specializes in fixed-income funds, particularly municipal bond funds. Like other mutual funds, investors in the preferred securities fund can buy shares or cash them in at any time, making the fund a safe starting point for investors trying their hands at preferred securities.

"A lot of people are scared of them," said Morningstar analyst Cara Scatizzi. "These types of funds are a good way to get into preferred securities. The appeal of the fund is that you can have your money spread across hundreds of preferred securities."

Higher yields from preferred securities have made them appealing in the current low-interest environment for fixed-income investments. But anticipated increases in interest rates on U.S. government bonds over the next year will compress the yield spread between corporate preferred securities and U.S. Treasuries, thereby lowering yields from preferreds.

Mr. Baker expects lower yields to be offset by higher prices for preferred assets, provided the U.S. economy continues to expand and inflation remains tame.

"There's the potential for this fund to be an all-season investment," Mr. Baker said.

Write to Bob Tita at robert.tita@dowjones.com