Digging in to Floating and Variable Rate Preferreds
As interest rates have continued to rise, a paramount concern for investors is how this environment will impact the yield and principal of their income-oriented investments. A popular approach is to eschew fixed-rate securities, which tend to have more interest rate sensitivity, in favor of floating or variable rate issues, which may see their coupons rise along with interest rates. In this piece, we look specifically into preferred stock to see if floating rate and fixed-to-floating rate preferreds can potentially mitigate the impact of a rising rate environment.
What are Floating and Fixed-to-Floating Preferreds?
Floating rate preferreds pay adjustable income levels, known as coupons, for the life of the preferred security. The formula for determining the coupon payment is usually benchmarked to 3-month ICE LIBOR (London Interbank Offering Rate) plus a fixed spread, which is based on the issuer’s credit risk. As interest rates rise, this formula dictates that the coupon payments to investors increase. Conversely, if rates fall, the coupon is expected to decrease. Given this adjustable coupon payment based on prevailing interest rates, these preferreds tend to have lower durations than fixed-rate preferreds.
Fixed-to-floating preferreds pay a fixed coupon amount for a specific period of time (typically 5 or 10 years) before switching to a floating rate coupon on a predetermined date. Fixed-to-floating preferreds typically have a duration close to the amount of years remaining until they convert to floating coupons.
How Common are These Securities?
While the US domiciled preferred market totals nearly $700 billion in value, floating rate preferreds make up just 3% of the total.1 Currently, there are just 14 constituents in the S&P U.S. Floating Rate Preferred Stock Index.2 Fixed-to-float offerings are more common than floating rate preferreds, making up roughly one-quarter of the preferred market.
Source: Bloomberg. Data as of 6/19/18.
Do these Preferreds Mitigate the Risks of a Rising Rate Environment?
At first glance, it would appear that floating and fixed-to-floating preferreds would be well-positioned to mitigate some of the risks of a rising rate environment. However, upon a deeper dive, we find that these securities come with a few features that may make them less desirable.
First, fixed-to-float preferreds are typically structured so they are callable once they switch from paying fixed coupons to floating ones. This means that if rates are rising and the issuer does not want to pay a higher coupon rate, they can simply call back the security, typically at quarterly or semiannual intervals. This feature ultimately can help protect the issuer from rising rates at the expense of the investor, who may never see the fixed-to-float security benefit from rising rates.
Second, floating rates can work both ways: they can result in either higher coupons than the fixed rate amount, or lower coupons, depending on a host of factors. Based on our research, we found that if all fixed-to-float securities were to convert to the floating rate period today, 55% would see their coupons increase over their fixed rates.3 However, in reality, the story is much different. Of the fixed-to-float and floating rate preferreds that are currently in the floating rate period, only 6% are paying a higher amount than their fixed rate or coupon floor.4 The data suggests that floating rate preferreds aren’t actually giving investors more income in today’s rising rate environment than fixed rate preferreds would. Part of the problem comes back to the call feature: the preferreds that would see a coupon increase when they start floating are likely to be called by the issuer.
To summarize, while fixed-to-float and floating rate preferreds appear to be a useful tool for mitigating the risks associated with rising rates, the reality is that the impact may be much more muted. Given that very few true floating rate preferreds exist, more investor exposure is to fixed-to-floating preferreds. Due to the continuous call option in most fixed-to-float preferreds, these securities often behave similar to fixed rate securities, or worse, as securities where the coupon is usually only falls in the floating rate period.
Fixed-to-float and floating rate preferreds remain an important segment of the preferred market, so they should not necessarily be avoided, but investors should be cognizant of the features presented in these securities. It may be more appropriate in this environment to think of this segment of the market as a complement, rather than a replacement, for the preferred part of a portfolio.
PFFD: The Global X U.S. Preferred ETF invests in a broad basket of preferred securities in the United States.
SPFF: The Global X SuperIncome™ Preferred ETF invests in 50 of the highest yielding preferred stocks in North America.