NEW YORK — Sometimes the middle road is the most exciting one.
Stock and bond mutual funds did well last year, but some of the best returns came from funds that sit somewhere between the two markets. Preferred-stock funds invest in securities that are a hybrid of stocks and bonds, and last year they delivered more income than many bond funds and bigger total returns than many stock funds.
Just don’t expect this year to be as good. Preferred securities still offer relatively big yields in a low-rate market in which savers are hungry for income, and fund managers say they expect another year of positive returns in 2015. But it’s doubtful that the mix of conditions that swept preferred funds to returns of more than 10 percent last year can happen again.
A relatively small corner of the market, preferred stocks aren’t what most investors imagine when they hear the word “stock.” They generally pay a fixed amount of income, and yields can top 5 percent, which looks particularly attractive compared with the roughly 2 percent yield of a 10-year Treasury.
• What went right last year? Like bond funds, the fortunes of preferred-stock funds swing with interest rates. When rates are falling, it’s a boon because yields of existing preferred securities suddenly look more attractive, and their prices rise. That’s what happened last year, when the yield on the 10-year Treasury sank from nearly 3 percent. The drop in rates helped preferred-stock mutual funds generate an average 11.4 percent return last year.
• What are the risks? Atop the list of concerns is the threat that interest rates will rise, which would knock down the prices of preferreds. The economy is getting stronger, and the Federal Reserve is generally expected to hike short-term rates this year for the first time since 2006.
Investors got a taste of the possible implications in 2013 during what’s become known as the “taper tantrum.” That was the period when the yield on the 10-year Treasury rose to roughly 3 percent, from less than 2 percent, on expectations that the Fed would wind down its bond-buying stimulus program.
• Why do managers still expect gains? Some fund managers expect long-term interest rates to rise only a modest amount this year. Phil Jacoby, for example, says the yield on the 10-year Treasury could end the year around 2 percent, close to where it is today, or even dip as low as 1.5 percent. He is one of the managers of the Principal Preferred Securities fund, the category’s largest mutual fund. A strengthening U.S. economy seems like it should be driving rates higher, but weakening economies elsewhere in the world and the plunging price of crude oil are exerting pressure in the opposite direction.
