Preferred securities are a unique, hybrid investment that share characteristics of both fixed-income and equity securities. Preferreds typically provide investors with a fixed payment, similar to a bond’s interest payment; however, they lack the guarantees a traditional bond has.
In terms of their capital structure, preferred securities are also subordinate to normal fixed-income instruments, yet above equities with respect to the order to claims of a company’s assets.This subordination within the capital structure leads to higher-yield compensation for investors. While bonds typically pay interest on a semiannual basis, preferreds tend to pay investors quarterly.
Additional characteristics include the fact that preferred shareholders have the right to distributions before equity holders; however, unlike equity holders, preferred shareholders do not retain voting rights.
WHAT BENEFITS DO PREFERRED SECURITIES PROVIDE?
Historically, preferred securities have provided higher yields relative to other investment-grade, fixed-income assets. Although higher yields are typically associated with noninvestment-grade companies offering what are sometimes considered “junk bonds,” preferred securities are generally issued by investment-grade companies like banks and insurance companies. This may allow investors to earn additional income for taking a subordinate position in a high-quality business’ capital structure.
In addition to the potential for higher relative yields, many distributions made by preferred securities are considered qualified dividend income (QDI), which is taxed at a preferential rate when compared to ordinary income ratio. This feature may lead to higher after-tax yield benefits compared to three categories: other investment-grade bonds; high-yield bonds, in some cases; and even municipal bonds in certain market environments.
Preferred securities tend to be somewhat underrepresented in investor fixed-income allocations. Yet an investor may increase portfolio diversification by allocating a portion of his or her fixed-income allocation to preferred securities. Historically, correlations among preferreds, equities and other traditional fixed-income asset classes have shown that diversification benefits have existed.
In the past, preferred securities were characterized as having a high degree of interest-rate risk during periods of rising rates. Although this may be a fair assessment for more traditional, perpetual preferred securities,many preferred securities in today’s market are structured as fixed-to-floating-rate or floating-rate.
In the case of fixed-to-floating-rate preferreds, the issue may have a predetermined period of a fixed yield, which then becomes variable going forward, based on a reference rate, which traditionally is LIBOR. A floating-rate preferred will have a variable rate from the beginning of its issue.
This structure can heavily influence the duration, or interest-rate risk, of preferreds and allows distribution yields to adjust as market interest rates move up or down. The current low-interest rate environment we are experiencing may lead to an increase in interest rates; thus, fixed-to-floating rate and floating-rate preferreds may actually be a more desirable structure for investments in the asset class.
HOW CAN AN INVESTOR ACCESS PREFERREDS?
The preferred securities market stretches around the globe and consists of approximately $875 billion in assets. Approximately three-quarters of this market is traded on the over-the-counter (OTC) market, consisting mostly of $1,000 par instruments.
The market is limited to institutional investors and consists of many of the fixed-to-floating-rate and floating-rate preferreds discussed earlier. Individual retail investors and ETFs have access only to the traditional stock exchanges, or approximately one-quarter of the preferred market. The retail market tends to contain $25 par instruments.
Because of their access to the OTC market, individual investors may benefit by utilizing institutional management in the form of a mutual fund. Mutual fund management teams should have access to both types of instruments and may provide additional oversight through active management, robust research capabilities and asset class expertise.
This article was originally published in the December/January 2016 issue of Worth.