In this episode of the Left Brain Thinking podcast, host Chuck Jaffe interviews Brian Dress, CFA and Director of Research at Left Brain Investment Research, about using preferred stocks as income‑generating securities. Dress explains that preferreds are hybrid instruments that sit between bonds and common equity, offering higher coupon yields (typically 7‑8%) than the high‑yield bonds the firm traditionally holds (4‑6%). He outlines the key risks: lower seniority in the capital structure (greater bankruptcy exposure) and interest‑rate risk on fixed coupons. The conversation centers on a concrete example, New Residential Investment Corp. Series A preferred (NRZ A), which yields about 7.63% and includes call protection until 2024, after which it converts to a floating‑rate (3‑month LIBOR + 5.8%) to mitigate rate risk. Dress describes how NRZ’s vertically integrated mortgage‑servicing, origination, and loan‑holding business provides a natural hedge against interest‑rate environments, making the security more attractive. Preferreds are positioned as a substitute for high‑yield bonds in income‑focused portfolios, with allocation levels depending on the investor’s growth versus income objectives. The episode concludes with standard disclosures and promotional information about Left Brain’s research newsletters and mutual fund.
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Hi, it's Chuck Jaffe, the host of the Left Brain Thinking podcast. And if you like what you hear and you want to get more insights from Left Brain Investment Research, check out the Jarvis newsletter, which highlights the weekly research outputs of Jarvis, Left Brain's proprietary research system. It's free and you can sign up to have it delivered to your inbox at leftbrainir.com/jarvisnewsletter. Welcome to Left Brain Thinking. Where creative investment ideas meet logical analysis. That's the hallmark of Left Brain Investment Research, where the analysts are looking for growth companies with the potential to double in 2 to 3 years and high-yield bonds with the potential for dramatic price appreciation. But today we're not going in the direction of either growth stocks or bonds. Instead, we're looking at preferred stocks, and we're doing it with Brian Dress, Director of Research at Left Brain Investment Research. You can learn more at leftbrainir.com. You can follow them on Twitter @leftbrainir. Brian Dress, great to chat with you again.
Hi, Chuck. Good to be back with you and the Left Brain listeners.
So preferred stocks, a little explanation of how they work, but a bigger explanation of how you guys at Left Brain can use them to fit the profile of the growth that you're looking for.
So Chuck, we've been on here the last few months talking to you about income securities. I just got back from the Morningstar Investment Conference speaking to advisors, and income securities and ways to find income for clients was definitely top of mind for many of them. And so we know how that goes, and we've seen that in-house as well. So we've been looking for ways to find income beyond just the high-yield bonds we usually work in. So we've moved our way down to preferred shares, and preferred shares are sort of a hybrid security. They have some of the characteristics of bonds and some of the characteristics of common stock. I would say they lean more to the bond side. They have fixed coupon payments, um, but they sit between bonds and, and common stock in the capital structure. So you have a little bit more protection than you would as a common stockholder, but the way it comes out in the wash is as a preferred shareholder, you find a little bit more income than you would in the bonds of the corresponding entity.
So what kind of returns are you shooting for? And what happens in terms of the risk scale? Because typically additional return comes with additional risk.
Sure. So we're kind of in that same ballpark as what we used to be with high yield bonds. You know, high yield bonds, average high yield bond is giving you somewhere in the 4 to 6 range, which is a little bit too low given the risks involved with some of the more indebted companies. When you look at a preferred, some of the preferreds we're looking at are more in the 7 to 8 range. So a little bit more return. There are a couple of risks. Again, like we said before, you're below bonds in the capital structure. So if there is a, a bankruptcy, you're less likely to be paid off. And then the other risk that you have is similar to what you have with bonds, which is interest rate risk. So with a fixed coupon payment, you know, if interest rates were to spike, the purchasing power of that coupon payment that you're receiving would decrease. So that's definitely an issue for preferred shares.
Is there a poster child for the kind of thing that you're looking for in preferred stocks right now? An example, cuz you guys are usually pretty good about talking about what you like?
And we always have an example, Chuck. Today it's NRZ A, Preferred Share A on New Residential Investment Corp.
Explain the terms and conditions here, why you like it.
So NRZ got started with mortgage servicing rights, and MSRs are basically a fee that's collected by a company like NRZ to collect payments to a mortgage originator and then forward those over to the originator. So that's a business that's done well for them. They're a traditional REIT, real estate investment trust. They've been doing the mortgage servicing rights for a decade or so. But the company has definitely been diversifying itself. As our analyst Madhu Chaudhry has said, it's now a vertically integrated business through 3 acquisitions in the last few years. They're now in the mortgage origination game and also holding on to some of those loans as well. So the company is able to collect fees at all levels of the mortgage value chain.
In terms of holding this, it's playing what role in the portfolio? Is it a sub for some of the high-yield bonds, a straight out you want to be using this in place of high-yield bonds, and what percentage of the portfolio you're letting preferreds like NRZA be? And then the secondary side is the expected return off of this.
This is definitely a substitute for some of the high-yield bonds that we used to have in client portfolios. Again, you know being able to collect 4% or 5% on a CCC bond isn't really very attractive to us. And so we're definitely looking for ways to replace securities like that. So that's where it fits into the portfolio. So it all depends on, you know, if you're a growth investor, probably not a lot. If you're an income investor, you know, a significant portion of your income securities, I think, could go in this preferred bucket. And we're working on a list here in-house. We've probably got 25 preferreds that look good to us. So we could definitely put together a portfolio of those type of securities for folks that are looking for income. Um, and you got to remind me of the second question, Chuck.
The second question is, it's a preferred security, the expected payout is what?
Sorry. So this preferred A, the Series A preferred for NRZ is yielding right around 7.63% annually at current prices. It also has call protection until 2024. So, you know, it'll be locked in until at least that point. And we also talked about that interest rate risk. Some of these issuers of preferred shares have realized that interest rate risk is definitely an issue for investors. And so they've done a novel thing, which is, you know, after that call date, this becomes a floating rate preferred, which means you won't just get that 7.5% coupon anymore. You will get 3-month LIBOR plus 5.8%. So you have a little bit of protection in terms of interest rate risk because of that provision.
And in terms of preferreds in general, is this at the high end? I mean, obviously terms and conditions are super important, making sure you're going to have that call protection, things along those lines. But is this the high end of what you're doing? Is this away from, from being too high? Because obviously returns come with risks. So where does this fit in the spectrum for you guys among all the preferreds you're looking at?
So this actually is a little bit on the high side of Like I told you, we have about 25 preferred on a list that we like, and they probably run anywhere, anywhere between 6% and 8%. So a little bit on the high side, but we do feel pretty strongly about this business. Like I said, there's that vertical integration. Now our analyst Madhu Chaudhry said this is kind of a hedge to the business now. So when rates are low, interest rates are low, these MSRs are not worth as much because there are prepayments. But now that they have an origination business as well, when those rates are low, the origination business tends to do well. So there's a natural hedge in this business. And so it makes us feel a little bit better in terms of, you know, how it works in terms of any type of interest rate environment.
Ryan, really interesting. Thanks so much for joining me to talk about it.
Thanks, Chuck. Great to be with you again.
Our conversations here on Left Brain Thinking are not personalized investment recommendations. They're designed to engage your brain. Please do your diligence before making any financial transaction. Left Brain Thinking is a joint production of Left Brain Investment Research and Money Life with Chuck Jaffe. That's me, and you can learn more about my weekday hour-long podcast at moneylifeshow.com. Thanks to my guest, Brian Dress, Director of Research at Left Brain Investment Research. Learn more about the firm at leftbrainir.com and sign up there for the new free weekly Jarvis newsletter, which highlights the insights gained from the outputs of Jarvis, the firm's proprietary research system. If you want to look into Left Brain's new mutual fund, details are available at leftbrainfunds.com, and the firm's on Twitter @LeftBrainIR. Left Brain Thinking is available every other Wednesday. Subscribe on your favorite podcast app, and until we don our left brain thinking cap again, happy investing, everybody.
