Should Investors be Concerned with Preferred Stock Ratings?

The question above is asked by our reader Kyle, who also asked if he should stick to just investment rated issues?

While the more seasoned income investor knows the answer to this question not everyone has been investing for the 40 plus years like some of us more “mature” folks. We will take this opportunity to cover a few of the basics about preferred stock ratings.

First off, there are 3 primary rating agencies that deal with preferred stocks. Standard and Poors, Moodys and Fitch. AM Best will occasionally deal with insurance related preferreds.  Each of the rating agencies has there own ‘grading system’, but they generally break issues down into 2 categories–investment grade or speculative grade (junk).We cover the Standard and Poors and Moodys rating system here. Each of the websites of these companies allows you to sign up for a free account from which you can find out plenty of details on their rating systems.

Rating agencies are hired by either the company, or in some cases the underwriter, of a new issue to assign a rating to a issue. Of course the rating agency has to carefully review all the financials of the issuer company as well as reviewing all the particular terms and conditions of the new offering. From this they can determine a specific ‘grade’ to assign to the issue. We found out after the financial crisis of 2008-2009 that ratings agencies where not nearly as good as they would have you believe as they mis-rated dozens (or hundreds) of issues.  It turns out that ratings agencies didn’t want to ‘bite the hand that feeds them’ and they over rated many issues. Hopefully most of these issues have been put behind us now.

Companies hoping to garner the best (lowest) available interest rate for their issue have little choice but to have one of the rating companies rate their issue. To not have a rating essentially means you are issuing speculative grade securities.  To have a investment grade security means you will have a better chance of selling the issue at a low coupon. A warning is in order here. Under no circumstances should one depend wholly on credit ratings. It is always necessary to do your own due diligence on a particular issue–a review of their website, reading the lastest 10Q or 10K (SEC filed quarterly and annual reports) and further searches on sites such as Seeking Alpha for others opinions of the issue are helpful.

It is noted that about half of preferred issues ARE NOT rated. In particular this is true of REIT preferred stocks which are a very large part of the market. We follow over 400 preferred issues of either $10, $25 or $50 par value and 166 are REIT preferreds and most are not rated.  1 exception are the issues of Public Storage (ticker:PSA) and PS Business Parks (ticker:PSB) which are both investment grade REITs and very large issuers of preferred stock. Other preferred stocks such as those of large cooperative CHS Inc (Cenex Harvest States) are not rated, but as we review these shares we believe CHS to be investment grade–or very nearly so.  Banks are another large issuer of preferreds and generally speaking they have their issues rated.

So as one can see if you want only rated preferred stock issues in your portfolio you have essentially eliminated almost 50% of the issues immediately.  If you want to hold only investment grade issues you cut another 20% out of your options.  In total you have likely cut down your options by 70%.

We must note here that we are talking about true regular preferred shares.  Our discussiondoes not include ETD (exchange traded debt) or Trust Preferreds. These sectors are very similar, but yet different in important ways compared to regular preferred shares.  The most important difference is these 2 sectors are both debt, instead of equity (Trust Preferred shares are considered debt and the income received is interest-not dividends). The other difference is that a majority these issues ARE rated by rating agencies.

So now that we have covered a good deal of the information relative to ‘ratings’ on preferred stocks we need to answer the question. Should one be concerned with preferred stock ratings or the lack of a rating? Unequivocally NO. Should one pay attention to and try to understand the ratings.YES. Should one learn to read 10Q’s and 10K’s so they can depend on their own due diligence? YES. 

Lastly, should one buy unrated preferred stocks? WE CAN’T ANSWER THAT QUESTION. While the majority of writers on sites such as Seeking Alpha continually use language such as ‘we recommend’ in their articles they really have no business doing so. It is impossible to have blanket recommendations about what someone should do with their investment funds. Each and every investor is a different age, has a different financial goal, has different family needs, has a different current income etc., etc. etc. Because each person is different there can be no blanket recommendation and we never use that word when we write–we can only write about what we do given our circumstances and then provide information from which one can make their own decisions.  If one is new to preferred stocks they should learn all they can and if they are ready to take the leap maybe buy 1 solid investment grade preferred and observe it for a month or 2. There is no need to jump in with all your funds without understanding what you are buying.