Summary The preferred stock market has come to be seen by many investors as a refuge in post financial crisis markets. But for those allocated to the preferred stock space, now is not the time for complacency. Preferred stocks have not been without their own past periods of extreme downside volatility. And the asset class resides worryingly close to the current wildfires now blazing in the high-yield bond market. The preferred stock market has come to be seen by many investors as a refuge in post financial crisis markets. Price performance has been notably consistent and income has been relatively generous at a time when those living on fixed incomes are starving for yield. And unlike other high-yielding markets such as high-yield bonds (NYSEARCA: HYG ) and master limited partnerships (NYSEARCA: MLPI ), it has not fallen victim in recent years to sudden bouts of unsettling downside volatility. But, for those allocated to the preferred stock space, now is not the time for complacency. Preferred stocks have not been without their own past periods of extreme downside volatility. And the asset class resides worryingly close to the current wildfires now blazing in the high-yield bond market. Preferred Stocks: A Lot To Like Up until recently, I had been meaningfully allocated to preferred stocks for some time. The reasoning for this maximum strategy allocation to the asset class was driven by the fact that there is a lot to like about the preferred stock space. First, preferred stocks were a more fairly valued option in an otherwise richly-valued high-income universe. Preferred stock yield spreads relative to U.S. Treasuries have been fairly consistent throughout the post-crisis period. According to the iShares S&P Preferred Stock Index (NYSEARCA: PFF ) relative to a benchmark 10-year Treasury yield, the current spread is at 3.7%, which is in the middle of the post-crisis range and well above the levels seen prior to the financial crisis in 2007 when this spread had dipped below 2%. (click to enlarge) And on an absolute basis, yields have remained relatively attractive at above 6% after cresting as high as 7% in late 2014. And this absolute yield is consistent with what we have seen from the category over the past decade. (click to enlarge) Adding further to the appeal of the preferred stock asset class has been the relative quality advantage enjoyed by preferred stocks relative to other higher-yielding alternatives. For although owning preferred stocks in their various structures rank lower on the capital structure than the offerings in the high-yield bond space, investors are standing on the rungs of higher-quality companies that boast credit ratings that are “A” or better in many cases. Moreover, a vast majority of the preferred stock universe at more than 80% is made up of companies in the financial sector. While this dedicated sector exposure proved highly problematic during the financial crisis (more on this point later), in the current environment, it actually represents an advantage. For example, more than half of the preferred stock universe is made up of issuance from the systemically important financial institutions such as Bank of America (NYSE: BAC ), Wells Fargo (NYSE: WFC ), U.S. Bancorp (NYSE: USB ), JPMorgan Chase (NYSE: JPM ) and Goldman Sachs (NYSE: GS ) among others. And the one thing that has been relentlessly demonstrated by monetary policymakers during the post-crisis period is that the health of these institutions will be guarded and protected by policymakers at all costs no matter what new operational missteps are made in the future. So, for all of these reasons, the preferred stock space has been an ideal destination for capital during the post crisis period. And the consistently strong price performance from the asset class has been rewarding in recent years. (click to enlarge) But market conditions have been changing in 2015. And the risks are now rising for what has been a placid destination in recent years. A History Not Without Trauma While the last few years have been a blissful period for preferred stock investors, this has not always been the case. The asset class has endured its own periods of extreme trauma throughout history. (click to enlarge) For example, during the financial crisis, while the stock market as measured by the S&P 500 Index (NYSEARCA: SPY ) fell by more than -50% from peak to trough, the preferred stock universe performed measurably worse in falling by nearly -65% over the duration of the crisis. Of course, much of this downside was driven by the heavy weighting to financials in the asset class. And while this characteristic may imply a degree of downside protection today, if we do find ourselves in the midst of another global financial accident, the category would likely suffer disproportionately once again under such a scenario. The Threat Of Collateral Damage Today The larger risk facing the preferred stock universe today is the threat of collateral damage spilling over from the high-yield bond space. Why exactly would challenges in the lower credit quality segment of the high-yield bond space impact investment-grade-rated preferred stocks largely concentrated in financials? Because many of the money managers that operate in the high-yield bond space are also the same investors actively involved in owning other high-yielding investments such as senior bank loans (NYSEARCA: BKLN ), convertible bonds (NYSEARCA: CWB ) and preferred stocks. Why would this matter? Because, if you are a money manager that is in a cash crunch and the high-yield bonds that you own have turned illiquid, you will likely turn to sell the other higher-quality assets that are still liquid in order to raise cash. This is where the contagion effects of illiquidity in a certain segment of financial markets starts to spread. For just like the high-yield bond space, the preferred stock universe is not the most liquid category in financial markets despite the fact that these securities trade on an exchange. While some of the larger preferred stocks trade with reasonable volume under normal market conditions, it is nothing like what is seen in the common stock market, as bid-ask spreads are often wide on any given trading day. And a fair number of preferred stocks trade with volumes in the thousands to hundreds on any given day with some periodically going untraded on any given day. As a result, if liquidation pressures were to spill over into the preferred stock market in earnest, we could quickly see staggeringly dramatic intraday price movements that can extend for days, weeks or even months depending on the degree of market stress. For the nimble investor, such dramatic dislocations can present incredibly good buying opportunities to snatch up high-quality preferred securities at dramatic discounts that eventually provide robust capital gains with attractive yields paid along the way. But, for many retirees that are not interested in trading the wild swings of the preferred stock market but instead simply want to clip their coupons and sleep well at night, such wild price deviations can prove devastatingly traumatic, particularly if they are unaware that they may occur at any given point in time and be accompanied by the periodic dividend suspension and/or bankruptcy like those experienced by Lehman Brothers’ preferred stock investors back in 2008. Where Do We Stand Today? To date, the preferred stock universe as a whole continues to hold up fairly well. The asset class as measured by the iShares S&P Preferred Stock Index reached a dividend adjusted all-time high as recently as the end of November. And while the high-0yield bond market has fallen precipitously since the start of December with a more than -6% decline, the preferred stock market is lower by only a fraction at just over -2%. In short, all remains reasonably well. But not entirely so, as several cracks warrant attention. First, preferred stocks started the week on a troubling note. Preferred stocks opened lower and faded throughout the trading day, effectively ending on their lows. This stood in sharp contrast to high-yield bonds that found their footing around 11:30AM today and traded sideways for the remainder of the day. Monday was only one trading day, but investors are well served to monitor this recent development for any continuation to the downside, as this would suggest that the problem in high yield is starting to spread. (click to enlarge) Second, standing back and taking a broader view on preferred stocks, not only is the category now precariously perched on its ultra long-term 400-day moving average, but also as evidenced by its price chart dating back to the summer, it is prone to flash crash pressures like experienced on the wild trading day of August 24. (click to enlarge) Lastly, while the preferred stock universe in general continues to hold up, specific segments of the space are breaking down. During the financial crisis, it was financial preferreds that were obliterated while non-financial preferreds (NYSEARCA: PFXF ) largely held their own. This time around, non-financial preferred stocks from industries such as telecommunications, agriculture, healthcare services, oil & gas, mining and pipelines have deviated from the path of the broader preferred stock universe and have instead latched on to the high-yield bond path lower. (click to enlarge) Thus, while the preferred stock market continues to hold up, it is warranting increasingly close attention going forward, as risk levels are rising both around and within the asset class. Recommendations Much like the high-yield bond and master limited partnership investors that have now gone before, preferred stock investors would be well served to have a heightened level of risk awareness going forward. It may very well be that preferred stocks emerge unscathed from this latest episode of capital market stress. Then again, they may eventually fall victim to the spillover effects that are now dogging related asset classes. Does any of this suggest that the asset class will suddenly head straight to the downside tomorrow? Not at all, for it may take a fair amount of time before the preferred stocks succumb to any downside pressure if at all. And even if the category begins to buckle, it is likely to do so with fits and starts over a more extended period of time. But the fact remains that risk environment surrounding preferred stocks has been elevated from where it has been over the last several years. If nothing else, a heightened degree of price volatility should be expected going forward. Disclosure : This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.