Preferred stocks are what’s known as hybrid securities, meaning the asset class displays both equity and fixed income characteristics.
The equity-like traits of preferreds can support gains when traditional stocks are rising. Likewise, the bond-like nature of preferred securities implies some sensitivity to interest rate fluctuations, a point amplified by the large yields thrown off by individual preferred stocks and exchange traded funds such as the SPDR ICE Preferred Securities ETF (PSK ).
It’s understandable that PSK stumbled last year as interest rates surged, sending stocks and bonds lower in unison. PSK is higher by nearly 3% year to date. That’s far better than the almost 1% sported by the Bloomberg Aggregate Bond Index. That could be a sign market participants are comfortable the Federal Reserve might not increase interest rates again anytime soon.
Preferred Stocks Have Potent Income Prospects
As noted above, preferred stocks, though not as bond-like as junk corporate debt, offer investors large income potential. With a yield of 5.43%, PSK proves as much.
“Preferreds compare favorably to dividend paying stocks, investment-grade corporate bonds and the broader bond market. While they may have a similar yield to high yield bonds, it’s worth pointing out that the index representing preferreds shown below is all investment-grade rated,” according to State Street Global Advisors (SSGA). “While the ICE BofA Hybrid Preferred Securities Index consists entirely of investment-grade rated securities, it is important to note that not all preferred stocks are rated by ratings agencies.”
PSK and preferred stocks offer another, often overlooked perk that advisors may want to consider discussing with income-hungry, tax-sensitive investors. Many PSK holdings pay qualified dividend income (QDI). This is often taxed at more favorable rates than common stock dividends or interest on standard bonds.
“Taxed at roughly 20%, QDI rates can be considerably less than ordinary income rates. Since preferred securities are hybrids of stocks and bonds, certain preferred securities generate qualified dividend income,” concluded SSGA. “This type of income is typically created by common stocks and taxed at the lower capital gains tax rate. In contrast, traditional fixed income investments create income subject to ordinary income tax rates (up to 37% based on current tax brackets).”
The $836.8 million PSK turned 14 years old earlier this month and holds 148 preferred stocks with an average yield-to-worst of 6.41%, according to issuer data.
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