The hunt for income in a challenging market year for both equities and bonds has many advisors searching further afield from more traditional allocations. One income option worth consideration is preferreds because of its hybrid nature that falls somewhere between fixed income and equities. Before jumping in, it’s important to understand how they work and the risks they carry.
Traditional preferred securities, or preferreds — also known as hybrid investments — are equity securities that have qualities similar to bond investments. Preferreds tend to be more correlated to the stock market than the bond market due in large part to their complex nature. They are issued most often by the banking sector, insurance, and real estate sector but utilities and other financial institutions will also issue preferreds.
Companies issue preferreds as a way to help provide financing flexibility and meet regulatory requirements to maintain their capital ratios. Because preferreds fall between stocks and bonds, they form a sort of added financial bubble of sorts between a company’s corporate bonds issued and its stock, creating an additional well of debt to draw from as needed.
“Preferreds offer attractive yields with less credit risk when compared to high yield bonds providing diversification benefits,” explained Todd Rosenbluth, head of research at VettaFi.
Preferreds are an enticing option because they can offer higher yield opportunities than many bonds with a lower investment per share. Preferreds are more liquid than similar quality corporate bonds and dividends are taxed at lower rates (20% qualified dividend income rate) than traditional income rates that max out at 37%. They are also often less volatile than stocks, a reality that cuts both ways in down and up markets, but they are sensitive to large market drawdowns.
They also fall higher than common stock on the ranking system should an issuer default (though they fall behind secured bonds), and largely are issued by banks that carry a low default rate as a sector. This also means that dividend payments must go to preferreds first before to common stock and most companies are deeply reluctant to miss a dividend payment to investors when possible.
Credit Risk and Interest Rate Sensitivity
Preferreds carry greater credit risk because a preferred security’s credit rating is generally lower than the same company’s senior bonds but still has a credit rating that’s usually higher quality than high-yield bonds. That being said, most preferreds are rated by well-established agencies such as Moody’s or Standard and Poor’s.
Preferreds are also sensitive to interest rates, though they carry less price sensitivity to changing interest rates than bonds. Because preferreds are largely issued by banks, changes in interest rates that affect the macro environment for banks and other financial institutions have hefty impacts because of the long maturity — or even no maturity — nature of preferred securities.
Preferreds are issued with a “call date” that is typically five to 10 years out from issuance but are callable by the issuer under several circumstances, including a change in the interest rates, tax changes, or capital requirement changes.
Bond and Equity Characteristics
Preferreds have many characteristics of bonds:
- They offer a regular source of income, typically in quarterly installments. The income can be derived from interest or dividends that is usually calculated based on a fixed rate percentage of the par.
- Fixed par values — the value issuers can redeem the preferred — at an entry-level for retail investors (usually $25) and institutional investors at a $1,000 par value.
- They have a set maturity date, or are perpetual with no maturity date, though most will have a “call date” that the issuer can exercise.
- There are a variety of rate structures that more closely resemble bonds for payouts, such as floating rate, fixed rate, or fixed-to-floating rate dividends.
The equity characteristics of preferreds:
- They pay dividends as opposed to the coupons that many bonds pay out, and dividend payouts come from after-tax profits of the company as opposed to bonds that are paid from pre-tax profits.
- Issuers are sometimes able to skip payments in times of severe market dislocation or economic stress, and missing a payment doesn’t trigger a default. This happens rarely, however, as missing too many payments would cause investors mistrust and reluctance to invest.
- Yields are calculated similarly to bonds (annual dividend divided by price) but because they are a higher-risk investment than bonds, their yields are generally higher in the market than a bond would be.
- In the event of a company bankruptcy, preferred stocks are paid out in a similar bracket as common stocks, though marginally ahead of them, but behind bonds.
- Preferreds don’t carry the obligation to pay like a bond would, instead functioning on a discretionary basis similar to stocks.
- Most preferred securities trade on exchanges just like stocks.
There exist several preferred types with a range of individual benefits and risks, but understanding the overall opportunities and risks inherent to this hybrid security is incredibly important for advisors and investors, particularly as market volatility continues.
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