In the current low interest rate environment, many investors are turning to preferreds for income, but it’s important to understand their risks as well as their advantages.

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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.

The Hunt for Yield

Bank preferreds are usually issued with yields that are well above other high quality income vehicles. Now that the Federal Reserve has recently lowered rates and indicated it may do so again if the economy weakens, the potential income generated from preferreds may seem even more attractive to investors. While the 10-year Treasury currently has a yield of about 1.5%, many preferreds currently offer yields of around 4-5%.

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. Most preferreds issue qualified dividends, which are taxed at the lower long-term capital gains rates (0% to 23.8% depending on an investor’s tax bracket) than traditional corporate bonds, the interest on which is taxed at ordinary income rates (up to  40.8% currently). This creates a significantly higher taxable equivalent yield: an investor in the top tax bracket must earn 6.43% in a corporate bond to match the after-tax yield of a 5% preferred (the difference between the top income tax rate vs. the long-term capital gains rate that applies to qualified dividends).

What Risks Come With Higher Yield?

Bank preferreds have higher yields mainly because they sit lower in the bank’s capital structure to other kinds of debt. 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.

Another risk investors need to be aware of is that many preferreds are now trading above their call price. Many of the issues within the more common $25 par structure have no maturity date but are issued with a five-year call provision. If the credit profile of the bank improves or interest rates fall (or both), the bank’s preferred stock may then trade at a premium. The so-called yield-to-call may be lower than the coupon yield alone.

 “Structurally, preferreds can come with varying degrees of call protection and coupon schedules,” notes Paul Servidio, an Executive Director and head of MSWM Fixed Income Sales. “It’s important that investors understand what they are buying.” Additionally, the investor may face reinvestment risk if the preferred is called and interest rates are then lower in the market.

The perpetual nature of a preferred also brings interest rate risk, as there is no set maturity date at which the issuer must redeem the security. If longer term interest rates go higher, the price of the security may dip, and vice versa.

Investors who want to mitigate this risk can invest in what are known as fixed-to-floating rate preferreds. These preferreds pay a fixed coupon for a set period of time. Then, if not called, the coupon floats to a fixed spread over a named benchmark (currently Libor though the Secured Overnight Financing Rate may be a future replacement). Many of these securities have a par value of $1,000 and have traditionally been an institutional only product, but they are increasingly available to individual investors as well. 

A final risk worth mentioning: 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.

Financial Strength of Banks Is a Plus

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 Servidio.

While changes in short-term interest rate expectations could lead to fluctuations in pricing and trading levels, this fundamental strength may mean that there is limited risk that the high coupon payments of preferreds will be disrupted in the near future.

To learn more about preferred securities and how they might fit into your broader portfolio strategy, speak with your Morgan Stanley Financial Advisor (or find a Financial Advisor near you using the locator below).