At one time, preferred securities were part of the regular vocabulary of total-return-oriented investors. After some years of disinterest, they now are seeing a renaissance and increased issuance. This is in part due to changes in bank capital rules, which allow these securities to be considered as equity and additive to bank excess capital. It is also tied to the low-yield environment and the “qualified dividend income” tax treatment that many preferred issuances receive.
Preferred securities offer their unique structure, often higher credit quality, moderate exposure to interest rate fluctuations versus some other types of fixed income securities, and generous after-tax yields. In particular, we believe they can be appropriate for allocations within fixed income as a way to enhance overall yield.
Preferred Securities in a Nutshell
Preferred securities are equities with bond-like characteristics. Like common stock, they represent an unsecured interest in the issuing company with no scheduled principal maturity date (although they are often callable). Their dividend is generally higher than for common stocks and must be paid before that of common shares. Like bonds, they are issued at a par value (often $25 for traditional preferred), and they typically trade like fixed income instruments.
Investors should be aware of certain variations:
Fixed Rate: A traditional form of preferred securities offering a fixed rate of income in perpetuity. Although sharp changes in credit conditions affect price movements (as they would a corporate bond), in normal times they tend to be sensitive to Treasury rate fluctuations.
Fixed to Floating Rate: Make fixed-rate payments for a set period (often 10 years), after which the issuer can call the bonds or change them to a floating rate. This feature also limits interest-rate sensitivity.
Variable Rate: Similar to floating rate loans, payments are usually tied to a short-term benchmark like Libor. This makes them particularly insulated from rising rates, though susceptible to lower rates as well.
Fixed to Fixed Rate: Pay a fixed interest rate that resets every five years if the security is not called at par (capital returned to investors) by the issuer, which reduces interest-rate sensitivity. These securities are generally only available to institutional investors.1
Implicit Credit Quality
In a low-rate environment, bond investors often stretch for yield by moving down the quality spectrum. For example, the spread between Treasury and high yield bond yields has narrowed in the wake of the long expansion, and carries risk if the economy loses momentum.
Preferred securities have traditionally offered attractive yields because of their unsecured status and the ability of companies to suspend or eliminate dividends. As such, the securities may carry credit ratings that are non-investment grade or at low levels of investment grade. However, the issuers are often investment-grade quality, and their overall balance sheets and cash flows are generally strong. Many issuers are in the financial sector, and while this represents industry concentration risk, rarely have banks been better capitalized than today, following strengthened government regulations that mandate higher levels of reserve capital and lower levels of balance sheet leverage.
Moderate Interest Rate Risk
As mentioned, the terms of preferred securities vary, with different levels of interest rate risk. For investors who want yield with lower rate sensitivity, holding a component of variable rate preferreds (fixed to floating, floating rate) will help keep duration (sensitivity to rates) in check.
Preferred securities’ current combination of high underlying issuer credit quality and limited duration is supported in the display below.
Credit Risk and Interest Rate Risk
As of June 30, 2019
Source: Bloomberg, JP Morgan. Indices as follows: U.S. Treasury: U.S. Generic Government 10-Year Yield; Munis: Bloomberg Barclays Municipal Index; U.S. IG Credit: Bloomberg Barclays Investment Grade Credit Index; Preferreds: ICE BAML Core Fixed Preferred Index; High Yield: Bloomberg Barclays High Yield Index; EMD Blend: 50% JPMorgan GBI Emerging Markets Global Diversified, 25% JPMorgan EMBI Global Diversified and 25% JPMorgan CEMBI Diversified.
Healthy After-Tax Yields
Like common stock, many preferred securities provide qualified dividend income (QDI) that is taxed at capital gains rates rather than ordinary income tax rates, which tends to result in a yield advantage compared to many yielding instruments, as shown in the chart below. Higher income tax rates apply not only to high-quality Treasuries and corporate bonds, but also to lower-quality assets like high yield bonds, as well as to emerging markets debt (EMD), which has tended to carry a higher yield than other fixed income investments of similar quality. Preferred securities now fare especially well on an after-tax basis when compared with municipal bonds, which experienced a surge in price (and a reduction in market yields) after tax reform increased the perceived value of federally nontaxable investment income. This could be worth noting for many individual investors who rely on municipals for income generation in retirement.
Pre- and After-Tax Yield
As of June 30, 2019
Source: Bloomberg, JP Morgan. Indices as follows: U.S. Treasury: U.S. Generic Government 10-Year Yield; Munis: Bloomberg Barclays Municipal Index; U.S. IG Credit: Bloomberg Barclays Investment Grade Credit Index; Preferreds: ICE BAML Core Fixed Preferred Index, High Yield: Bloomberg Barclays High Yield Index; EMD Blend: 50% JPMorgan GBI Emerging Markets Global Diversified, 25% JPMorgan EMBI Global Diversified and 25% JPMorgan CEMBI Diversified. After-tax yields based on 37% tax rate, applied to all taxable asset classes except Preferreds; Preferreds taxed at 23.8% QDI tax rate for 60% of the portfolio and 37% for 40% of the portfolio. 60/40 split based on the proportion of the BAML index that is/is not eligible for QDI tax treatment.
Preferred securities have compelling advantages, but investors should understand the risks:
- Although issuers are often investment grade, the securities are subject to credit risk that should be assessed as part of a research process and priced accordingly.
- While similar to bonds in many respects, preferreds’ unsecured place in the capital structure can make them behave like equities at times should an issuer or market fundamentals deteriorate.
- Preferreds tend to concentrate in the financial sector (around 60% of issuers) due to regulatory and structural benefits to issuers. The good news is that financial companies are much more financially sound than they were a decade ago, but diversifying within subsectors is worthwhile.
- As mentioned, various types of preferreds have different rate sensitivity, so depending on your investment profile, favoring variable rate securities can make sense to offset this risk.
- Another risk is the price decline to par value that some of these issuers experience as they approach their call date, if they are redeemable by the issuer.
- Finally, the tax-advantaged status of preferred securities makes them vulnerable to changes in regulation or tax treatment. No changes are on the table currently, but the political winds could change.
Building Preferred Securities Into a Portfolio
In discussing the characteristics of preferred securities, our point is not that they act as a one-for-one substitute for any other asset class. Treasuries still can provide ballast in market panics or economic slowing. Municipal bonds remain a cornerstone of individual portfolios in light of credit quality and federal and state tax-advantaged income. Treasury inflation-protected securities (TIPS) currently offer value in light of lowered inflation expectations. And EMD, high yield bonds and floating rate loans, while carrying their own risks, can offer valuable diversification and yield benefits. However, preferred securities can provide a rare combination of yield and credit quality that bears considering in an environment where investment income is hard to come by.