Investors seeking yield often turn to traditional allocations, such as dividend paying stocks, investment-grade corporates, or high yield bonds. Preferred shares (“preferreds”) frequently go overlooked — but this unique asset class offers several advantages worth considering.
Preferreds, which offer income potential, are securities that are generally considered hybrid investments, meaning they share characteristics of both stocks and bonds. They can offer more predictable income than do common stocks and are typically rated by the major credit rating agencies. Yet, because preferred shareholders have lower priority in the capital structure as compared to bondholders, the ratings on preferred shares are generally lower than the same issuers’ bonds. Although, the yields on preferreds typically are above those of same issuers’ bonds to account for the higher credit risk.
The designation “preferred” refers to the security’s treatment relative to common shareholders. Preferreds stockholders’ dividends typically have priority over common equity dividends. Preferred securities usually have long maturities or are perpetual with no maturity at all. There are two types of preferreds stock: cumulative and non-cumulative. Non-cumulative preferred stock does not repay unpaid or omitted dividends while cumulative preferred stock entitles investors to missed dividends. If a company with cumulative preferred stock suspends its dividend, these forgone dividends accumulate and must eventually be paid to preferred shareholders.
Companies may issue preferreds for a variety of reasons:
Preferred securities can have a variety of different coupon structures:
If they contain a call feature, preferreds may be called by the issuer after a certain date. The motivation for the redemption is generally the same as for bonds: a company calls in securities that pay higher rates than what the market is currently offering. While some preferred have seen refinancing with lower interest rate, many preferreds with high coupon rates remain outstanding, trading above their call prices for years due to a verity of factors that may impede the issuers from refinancing.
Some preferred shares are convertible preferred stocks that include an option for the holder to convert the shares into a fixed number of common shares after a predetermined date. More often than not, this feature is not at the election of the holder and is instead mandatory. Mandatory convertible preferreds automatically convert to common equity on or before a predetermined date, and therefore may behave in a more equity-like fashion than other preferred security types. The value of a convertible preferred stock is ultimately based on the performance of the common stock.
The case for preferreds and the role they can play as a diversified income generator within portfolios, is centered on four key aspects:
If yield is a key reason to consider preferreds, how does the asset class stack up against other income-generating choices? As shown below, preferreds compare favorably to dividend paying stocks, investment-grade corporate bonds and the broader bond market. While they may have a similar yield to high yield bonds, it’s worth pointing out that the index representing preferreds shown below is all investment-grade rated.1 While the ICE BofA Hybrid Preferred Securities Index consists entirely of investment-grade rated securities, it is important to note that not all preferred stocks are rated by ratings agencies.
Figure 1 : Preferreds Have a Higher Yield Than Most Common Market Segment
Key Takeaway: A potential 6%+ yield for a group of primarily investment-grade securities is worth considering for the income generation portion of a portfolio.
Beyond an attractive yield potential, many preferred securities pay qualified dividend income (QDI) rates, which may enhance after-tax yield. Taxed at roughly 20%, QDI rates can be considerably less than ordinary income rates. Since preferred securities are hybrids of stocks and bonds, certain preferred securities generate qualified dividend income. This type of income is typically created by common stocks and taxed at the lower capital gains tax rate. In contrast, traditional fixed income investments create income subject to ordinary income tax rates (up to 37% based on current tax brackets).2
One of the basic principles of portfolio construction is ensuring portfolios are properly diversified, seeking to balance risk and return by including assets with low correlations. A way to examine the potential diversification benefits of an asset class, and its use case, is to understand its correlation profile. For instance, if a fixed income exposure has a low correlation to other bond strategies but is highly correlated with equities, than its inclusion into the fixed income sleeve of a standard 60/40 equity/bond allocation may do two things:
If that is the intended goal, inclusion could be a good idea. In any case, understanding the cross-asset correlation profile of an exposure prior to implementation should be on the investor’s portfolio construction checklist. For preferreds, as they are both bond-and stock-like, their correlation profile is low relative to both asset classes, as shown below. Their correlation basic US Treasuries is very low at 0.13 over the last 15 years (based on monthly returns).3 They also have lower than 0.464 correlation to equity-sensitive high yield bonds and to equities themselves — from all parts of the world.
Figure 2 : Preferreds Have Low Correlations to Common Market Segment
Key Takeaway: Preferred shares have low historical correlations to traditional stocks and bonds, indicating that their return patterns may be differentiated throughout certain market environments, resulting in a potential portfolio diversifier.
As a result of preferred shares having both bond – and stock-like features, the volatility profile of preferreds has historically been lower than that of pure common stocks, while being just a touch below that of credit-sensitive high yield bonds, as shown below. For this analysis, we used the historical median rolling 36-month standard deviation of returns over the last 15 years, as a rolling measure can account for the cyclicality within an asset class. It is also more constructive than periodic returns, as one can examine outliers. For instance, preferred shares became more volatile than both high yields bonds and US large-cap stocks during the financial crisis due to the financial concentration within the asset class.5 The latter point may be helpful in understanding return patterns if there is a market event that creates short-term volatility in the financial sector.
Figure 3 : Preferreds Have Historically Had Lower Volatility than Stocks and High Yield Bonds
Key Takeaway: Due to the hybrid nature of preferred shares, the volatility profile is lower than that of common stocks — both traditional US large caps and the actual underlying common stocks of the same preferreds — and credit-sensitive high yield bonds. Therefore, preferreds add high income potential without taking on outsized volatility.
Preferreds may be an option for investors seeking some of the highest yields in the investment-grade universe while maintaining overall portfolio diversification.
Due to the unique features described earlier, investors can integrate preferreds into their portfolios with these goals in mind:
Figure 4 : Yield-Per-Unit of Volatility
Investors seeking a potential source of income should take a closer look at preferreds, as the elevated level of income coincides with potential tax and diversification benefits but is not the result of taking on high levels of volatility.
The SPDR® ICE Preferred Securities ETF (PSK) employs stringent credit-quality criteria and largely holds investment-grade securities. PSK’s index also excludes convertible preferred securities, meaning the fund may exhibit less equity risk than peers that include this security type. In order to avoid issuer concentration, the index also invokes a 5% issuer cap.
1 Bloomberg Finance, L.P., as of 12/31/2022.
2 IRS as of 12/31/2022.
3 FactSet 12/31/2007-12/31/2022.
4 FactSet 12/31/2007-12/31/2022.
5 Bloomberg Finance, L.P., as of 12/31/2022. The ICE BofA Hybrid Preferred Securities Index used to represent Preferreds, S&P 500 used to represent equities and the Bloomberg U.S. Aggregate Bond Index used to represent bonds.
6 FactSet, Correlation and Beta measured for the 20-year period ending 12/31/2022. ICE BofA Hybrid Preferred Securities Index used to represent Preferreds, S&P 500 used to represent equities and the Bloomberg U.S. Aggregate Bond Index used to represent bonds.
7 FactSet, Bloomberg Finance, L.P., as of 12/31/2022. The ICE BofA Hybrid Preferred Securities Index used to represent Preferreds. The Bloomberg High Yield Very Liquid used to represent High Yield. The Bloomberg U.S. Treasury 20+ Index used to represent Long Term Treasuries. The S&P High Yield Dividend Aristocrats Index used to represent US Large Cap Dividend Equities. Yield to Worst used to fixed income indices. Dividend Yield used for equity indices.
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