Preferred stocks are in the doghouse, and you just might be wondering whether this is the start of a buying opportunity.

Let me put that question to rest: it is.

Today we’re going to look at what’s behind this superb chance to buy, as well as 3 preferred-stock funds to consider: the Flaherty & Crumrine Dynamic Preferred & Income Fund (DFP), Flaherty & Crumrine Preferred Securities Income Fund (FFC) and John Hancock Premium Dividend Fund (PDT).

As you can see, all 3 of these funds are in the dumps.

A Steep Slide Down

But these are great funds, not only because of their sustainable 7% dividend yields and diversified portfolios, but also because this preferred-stock selloff is misguided.

A Panic We Can Profit From

So what’s causing the selloff? A couple things.

One is simple asset rotation. The market is worried that people will offload preferreds to buy common stocks. But this hasn’t happened yet, as you can see from the iShares US Preferred Stock ETF (PFF), which has flat-lined, even though the S&P 500 has soared:

A Market in Standby Mode

However, plenty of folks are still worried that it will, so they’re desperately trying to front-run selling that may never actually occur.

The other, and more important, fear concerns rising interest rates. The Federal Reserve has made it clear that rates are going up in 2018—at least 3 times and maybe more.

Why is this bad for preferred stocks?

For one, the dividend yields they pay would be less competitive against, say, Treasuries, whose yields will rise with rates. Higher rates could also make it tougher for the companies that issue preferreds to keep paying their dividends.

This first-level analysis is doubly wrong.

Lost in the noise is the fact that the Federal Reserve is raising rates because the economy is better. A better economy means more corporate profits, which means preferreds’ payouts are easier to cover. That, in turn, means more demand—and higher prices—for preferreds.

Don’t believe me? Let’s check the history.

During the last sustained rate-hike era, in the mid-2000’s, the Fed increased rates by over 300%—and 2 of the preferred-stock funds I mentioned off the top notched some nice gains (we can’t include DFP here because it wasn’t launched until 2013):

Preferred Funds Defied First-Level “Wisdom” in the 2000s …

While FFC clearly lagged because it’s a very conservative fund that tries to avoid volatility (thus limiting potential returns), it didn’t go down during the period, despite the sharp rise in rates.

Funny thing is, history has repeated in the rate-hike cycle we’ve seen in the last two years. Despite the recent declines in these preferred funds, all three are up solidly and had gained 30%, on average, before the start of the decline we’ve seen in the last couple months:

… and They’re Doing It Again

But the old fears are stirring up again, erasing recent gains in these solid funds.

Why Now Is the Time to Strike

So does that mean now is the time to buy preferred-stock funds?

In short: yes.

Remember that scary chart I showed you above, of the 3 funds falling by 6% in less than a month?

Keep in mind that this is a market price–based return, including the current market price and dividends. There’s just one important caveat to that 6% drop—and one that makes me confident this is a screaming buying opportunity.

Since these are closed-end funds (CEFs), which almost always trade at significantly different prices than the actual market price of their underlying portfolios (which is referred to as the net asset value, or NAV), these recent market-price declines are way off from the real underlying value of these funds.

If we look at the NAVs of these funds over the same time period, we see that they have barely budged at all.

Where’s the Selloff Now?

For PDT, this means that the premium to NAV (i.e., the difference between its market price and its portfolio’s real market value) has more than halved. It also means FFC and DFP have seen their premiums disappear—and turn into discounts:

Big Bargains for Smart Buyers

Part of this has to do with the fact that both FFC and DFP recently cut their dividends—but the newly cut dividends still leave these funds with yields of 7.2% and 7.1%, respectively.

Those are still HUGE payouts! And in the case of FFC and DFP, those yields are being sold for less than the market prices of the cash flows that support them. If that doesn’t make for a great buying opportunity, nothing does.

— Michael Foster

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Why do I say that?

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That’s just the start, though.

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Source: Contrarian Outlook