With their attractive yields and tax advantages, preferred stocks may warrant a closer look for income investors searching for yield.
Periods of low interest rates create a unique problem for yield-oriented fixed income investors. As the current rate environment persists, some investors are viewing preferred stock as an increasingly attractive alternative to more traditional yield products.
“It’s hard to find yield in the fixed income markets, especially with the ten-year US Treasury around 2%,” says Kevin Lynyak, Head of Trading at Morgan Stanley Wealth Management Capital Markets.
This is where preferred securities, often referred to as “hybrids” due to the presence of both debt and equity characteristics, may offer a solution for fixed income investors seeking higher risk-adjusted returns.
“To find yield in the current interest rate environment, you really have to take some type of risk. While preferred securities resemble other types of fixed income investments which also have credit risk, interest rate and structure risk, the primary risk for which the investor is compensated is subordination risk,” says Lynyak.
In simplest terms, subordination risk is the risk of holding debt which ranks after other debts if a company falls into liquidation or bankruptcy. Preferred stock ranks above common stock in priority of payment, but is junior to all other forms of interest-bearing debt.
“Preferred Stock investors receive incremental yield versus senior debt for assuming subordination risk, along with a tax advantage on qualified dividends versus ordinary income on bonds,” says Lynyak.
While different types of companies have issued preferred stock in the past, the vast majority of issuance now comes from banks who issue preferred securities to satisfy various regulatory constraints.
"US bank preferreds continue to improve from a credit perspective. There was a lot of issuance after the 2009 financial crisis in the wake of Dodd-Frank and Basel III, but we think that supply will begin to abate as banks reach required capitalization levels," he adds.
In recent years, due to market demand, banks have issued fixed-to-floating rate dividend preferreds. In such structures the dividend rate is fixed for only an initial time horizon, the two most common being five or ten years. Immediately following this fixed rate period, the issuer has the option to redeem the security at par. If not called at the first possible date, the security will float at a predetermined spread to an interest rate benchmark (typically 3-month US dollar LIBOR). The floating rate dividend generally resets quarterly.
"If you're worried about duration, or interest rate risk, the typical fixed-to-floating rate preferred structure offers a fixed dividend for five or ten years and then the dividend will typically adjust with 3-month LIBOR plus the spread,” says Lynyak.
"This means that if we see higher rates at some date in the future, you'll have some protection on that. In other words, investors have the potential to participate in higher interest rates," says Lynyak.
As with any investment, there are risks and considerations to take into account. "Most preferred stock tends to be perpetual, so investors should have a favorable long-term view on the issuer’s health prior to investing in the company’s preferred securities.”
On the other hand, fixed-to-floating rate preferred stock can lessen interest rate risk as its floating dividend dovetails with future benchmark interest rate moves.
In terms of credit risks with US bank preferred stock, regulators (namely, the Federal Reserve) have mandated that the largest US banks must hold significantly higher levels of capital following the 2008 financial crisis. In addition, the Federal Reserve has been conducting yearly stress tests on these banks to determine the resiliency of this capital in a variety of domestic and global stress scenarios. As a result, subordination risk for US Banks can be more attractive than other kinds of risk such as liquidity, interest rate risk and duration.
Talk with your Morgan Stanley Financial Advisor to learn more about preferred securities and how they might fit into your broader portfolio strategy.