With their relatively attractive yields and potential tax advantages, preferred stocks may warrant a closer look for income investors searching for yield.
With the ten-year U.S. Treasury hovering between 2% and 2.5% and yield hard to find across the fixed-income universe, yield-focused investors have seen their fair share of challenges. As the current low rate environment persists, some investors are viewing preferred stock as an increasingly attractive alternative to more traditional yield products.
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 returns.
The Risk of Return
To find yield in the current interest rate environment, investors may opt to take on more 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.
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 generally junior to all other forms of interest-bearing debt.
Preferred Stock investors typically receive incrementally higher yield versus senior debt for assuming subordination risk, along with a potential tax advantage on preferred stock that is eligible for qualified dividends versus ordinary income on bonds.
A Look at U.S. Bank Preferreds
While different types of companies have issued preferred stock in the past, one of the largest issuers of preferred stock is banks who issue preferred securities to satisfy various regulatory constraints. And many of these U.S. bank preferreds continue to improve from a credit perspective.
Regulators (namely, the Federal Reserve) have mandated that the largest U.S. 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.
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.
For investors worried about duration, or interest rate risk, the typical fixed-to-floating rate preferred structure offers a fixed dividend for five or ten years. After that, the dividend will typically adjust with 3-month LIBOR plus the spread. This means that if we see higher rates at some date in the future, investors will have some protection.
The majority of $25 and $1000 par preferred securities are “callable” meaning that the issuer may retire the securities at specific prices and dates prior to maturity. [Interest/dividend payments on certain preferred issues may be deferred by the issuer for periods of up to 5 to 10 years, depending on the particular issue. Price quoted is per $25 or $1,000 share, unless otherwise specified. Current yield is calculated by multiplying the coupon by par value divided by the market price.
The initial interest rate on a floating-rate security may be lower than that of a fixed-rate security of the same maturity because investors expect to receive additional income due to future increases in the floating security’s underlying reference rate. The reference rate could be an index or an interest rate. However, there can be no assurance that the reference rate will increase. Some floating-rate securities may be subject to call risk.
Some $25 or $1000 par preferred securities are QDI (Qualified Dividend Income) eligible. Information on QDI eligibility is obtained from third party sources. The dividend income on QDI eligible preferreds qualifies for a reduced tax rate. Many traditional ‘dividend paying’ perpetual preferred securities (traditional preferreds with no maturity date) are QDI eligible. In order to qualify for the preferential tax treatment all qualifying preferred securities must be held by investors for a minimum period – 91 days during a 180 day window period, beginning 90 days before the ex-dividend date.
Credit Risk The possibility that the issuer might be unable to pay distributions and/or principal on a timely basis is known as credit risk. The rating agencies, such as Moody’s, Standard & Poor’s and Fitch Ratings evaluate quantitative and qualitative factors to determine a credit rating, which is a measure of an issuer’s creditworthiness.
Call Risk The majority of preferred securities are callable, allowing the issuer to redeem them prior to maturity. If the security is called, the investor bears the risk of reinvesting the proceeds at a potentially lower rate of return. To compensate investors for the issuer’s early redemption option, callable preferred securities typically offer the following: higher yields than their non-callable counterparts; a call protection period (usually five years from issuance) during which time the issuer cannot redeem the securities; and, in certain cases, a call premium, where the issuer pays the holder of a called security a price greater than their par value. Preferred securities generally have call provisions allowing the issuer to redeem them prior to their stated call date, provided a capital treatment, tax or regulatory event occurs, and if regulatory approval is received.
Interest Rate and Duration Risk The possibility that the market value of securities might rise or fall due to changes in prevailing interest rates is known as interest rate risk. Fixed income securities are susceptible to fluctuations in interest rates; all else being equal, if interest rates rise, preferred prices will generally fall, and vice versa. Duration is a measure of a bond’s price sensitivity to changes in interest rates. The higher the bond’s duration, the more sensitive its market value is to changes in interest rates. Your Financial Advisor can provideyou with the duration on your fixed income securities.
Secondary Market Risk Many preferreds are listed on securities exchanges, which may provide a higher degree of transparency. However, there is no guarantee that an active or liquid secondary market will exist for any individual issue. If a security is sold in the secondary market prior to maturity (or call date), the price received may be more or less than the face value or the original purchase price, depending on market conditions at the time of the sale. Prices can be volatile during periods of market turbulence, and some preferred issues will be more liquid than others.
Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.
Credit ratings are subject to change.
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