Learn why some investors are turning to preferred securities for tax-advantaged income.
Preferred stock, a kind of hybrid security that has characteristics of both debt and equity, is attracting more interest from investors who are seeking higher yielding investments in the current low interest rate environment. Mainly issued by financial institutions, preferreds have several advantages as well as some risks to be aware of.
Bank preferreds are usually issued with yields that are well above other high-quality income vehicles. As such, the potential income generated from preferreds may seem even more attractive to investors.
Supply and demand dynamics are a notable positive for bank preferreds at this time. After the financial crisis of 2008, banks issued a significant amount of preferreds to meet the new higher capital levels required by regulators. Now that many of those needs have been met, issuance has slowed. This has created a very positive technical backdrop for preferreds.
Tax treatment is another major advantage. While most investors, when looking for tax-advantaged investments, migrate to the tax-free municipal market, most preferreds offer tax-advantaged income in the form of qualified dividends. Qualified dividend income, which is taxed at the lower long-term federal capital gains rates (0% to 20%, depending on an investor’s taxable income bracket, plus the 3.8% net investment income tax for high earners)1, can offer an after-tax yield pickup versus traditional corporate bonds, where the interest is taxed at federal ordinary income tax rates (up to 40.8% currently). This creates a significantly higher taxable equivalent yield: An investor in the top tax bracket must earn roughly 5.15% in a corporate bond to match the after-tax yield of a 4% preferred (the difference between the top income tax rate versus the long-term capital gains rate that applies to qualified dividends). Each preferred stock issue has a prospectus that details the structure, helping an investor to determine the taxable nature of its dividends.
Bank preferreds have higher yields mainly because they sit lower in the bank’s debt capital structure. While preferred stock is senior to common equity on a bank’s balance sheet, it falls below all other creditors, including subordinated or senior unsecured debt. The risk is that in a bank liquidation, preferred shareholders would get little to nothing in recovery. This is known as subordination risk. Additionally, as most preferreds mainly pay dividends, not interest, the issuer has the ability to turn off the coupon indefinitely if its capital levels fall dramatically. Note, however, that this normally happens only if that issuer first eliminates its common dividend (generally not something a bank wants to do). This outcome seems unlikely in the near term as the banking sector remains soundly profitable and well capitalized with common equity.
A key risk that investors need to be aware of is duration risk, or the risk that changes in interest rates will affect an asset’s market value. While preferreds are typically issued with five- or 10-year call provisions, they are perpetual in nature, meaning there is no final maturity date. With many preferreds now trading above their par value and rates near historic lows, its important investors consider duration risk, in the event rates rise or spreads widen. Investors who want to mitigate duration risk can invest in what are known as fixed-to-floating rate or fixed-to-rest preferreds. These preferreds pay a fixed coupon for a set period of time. Then, if not called, the coupon floats or rests to a fixed spread over a named benchmark; London Interbank Offered Rate (LIBOR), Secured Overnight Financing Rate (SOFR) and Constant Maturity Treasuries are the most common.
The financial industry is moving away from LIBOR, which will no longer be published after June 30, 2023. SOFR is the alternative reference rate recommended by regulators and private-market participants.
LIBOR has been the subject of regulatory scrutiny due to concerns with the structural integrity of this interest rate benchmark and how it is determined. In response to these concerns, the U.S. Federal Reserve Board and the Federal Reserve Bank of New York created the Alternative Reference Rates Committee (ARRC), which has selected SOFR, a reference rate based on overnight repurchase agreement (repo) transactions secured by U.S. Treasury securities, as the recommended alternative benchmark rate to USD LIBOR. Certain other USD LIBOR alternatives exist in the market but have not been recommended by the ARRC.
Recent legislation enacted in New York provides for a benchmark replacement (a SOFR-based rate plus a spread) to replace LIBOR for those contracts governed by New York law without effective “fallback provisions”, which provide for how the applicable interest rate will be calculated if LIBOR ceases or is otherwise unavailable.
“With the creation of the ARRC, the Fed and regulators have shown a commitment to an orderly transition away from LIBOR into a new, market-accepted replacement benchmark,” Paul Servidio, Head of Wealth Management Fixed Income, Morgan Stanley, noted. “We are encouraged by the work they have done thus far, including the proposal of recently enacted legislation in New York to provide legacy contracts a benchmark rate to 'fall back' to if the prospectus does not properly specify a transition.
“However, we continue to keep our investors informed of any inherent risks when it comes to individual fixed-income investments linked to LIBOR, and believe it is important that investors have a full understanding of the unique contractual language within each these securities,” Servidio added. (For more information on the transition away from LIBOR and the recommended alternative rate, SOFR, contact your Morgan Stanley Financial Advisor or visit www.ms.com/wm/libor).
In the aftermath of the financial crisis, banks were required to significantly bolster their capital positions, creating a much stronger fundamental backdrop in the preferred space. “The strength of the financial sector now is a big reason we are comfortable suggesting that certain investors can consider moving down the capital structure with bank preferreds,” says Domenic Matera, Head of Taxable Fixed Income Sales & Trading within Morgan Stanley Wealth Management.
Bank capital was in the spotlight throughout the pandemic-driven recession, with investors asking how safe U.S. bank dividends were. “U.S. banks reacted quickly to the economic downturn and uncertainties by suspending buybacks. Although banks have now begun returning capital to shareholders, capital levels remain very strong and are only naturally coming down off a very high base,” says Domenic. “We view this more as a prudent use of excess capital than of deteriorating credit quality.”
To learn more about preferred securities and how they might fit into your broader portfolio strategy, speak with your Morgan Stanley Financial Advisor.