With interest rates scraping bottom, investors have been flocking to preferred stocks. Like bonds, preferreds pay a fixed rate of interest. But because preferred-stock holders are behind bond investors in the pecking order for a claim on a failed company’s assets, preferreds are riskier than bonds and, accordingly, pay more interest. And like bonds, prices of preferreds move in the opposite direction of interest rates, making preferreds dicey bets if you expect rates to rise.
Joel Beam, the manager of Salient Select Income (KIFAX)—one of only two mutual funds that focus on preferreds and offer a no-load, low-minimum share class—is ready for higher rates. Since 2012, he says, “we’ve been investing around the central idea that the economy is healing.” That has meant stocking his fund, which yields 5.5%, with more common stocks than usual (34% of the fund’s assets in late May).
As it happens, nearly all of Salient’s holdings are real estate investment trusts. From a pool of about 200 REITs, Beam finds attractive preferreds by targeting high-quality firms with unjustly low credit ratings. On the common-stock side, he looks for undervalued REITs, such as Sabra Health Care REIT and Chatham Lodging Trust. Because Beam believes many big REITs are richly valued, he also had a 7% short position (a bet on falling prices) in an exchange-traded fund that tracks a REIT index that tilts toward large firms.
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