Preferreds, Yield, and Your Portfolio
In this stubbornly low interest rate environment, traditional fixed income instruments have largely failed to provide investors with the income they desire from their portfolios. Previously, we have focused on high dividend stocks and REITs as asset classes to consider when looking for opportunities to potentially increase a portfolio’s yield. In this piece, we turn our attention to preferred stocks as another potential solution to investors’ search for yield.
With over $20 billion in net inflows into preferred ETFs since 2010, preferreds have become a popular alternative for investors trying to boost the yield of their portfolios.1 In this piece, we shed light on the preferred stock space by discussing the unique attributes of preferreds, including:
- What are preferreds?
- What are the yield expectations for preferreds?
- How can preferreds diversify a portfolio?
- What are some unique features of preferreds?
- How do preferreds fit into a portfolio?
Preferreds are considered hybrid securities because they possess characteristics of both fixed income and equity securities. Like bonds, they are yield-bearing instruments that typically pay a fixed distribution to investors. They are often issued at a par value, assigned credit ratings, and do not have voting rights. Like equities, however, preferreds trade daily on a stock exchange, have the opportunity for price appreciation or depreciation, can have their dividends suspended, and fall in the lower portion of a firm’s capital structure.
Investors are often drawn to preferreds given their primary focus on distributing regular dividend payments. Given that preferreds are junior on the capital structure to bonds and their dividends are less safe than a bond’s coupon payments, investors demand that preferreds pay a yield premium. As illustrated in the chart below, since 1997, the yield on preferreds has averaged nearly 240 basis points higher than the yield of corporate bonds. Compared to common stocks, their yield advantage has been nearly 570 basis points higher.
A sometimes overlooked advantage of preferreds is that their dividends are often taxed more favorably than bond coupons. Bond coupons are taxed as regular interest income, which can be as high as 43.4% for investors in the highest tax bracket.2 Dividends paid by preferred stocks are often eligible to be classified as qualified dividends (QDI), which are taxed at long term capital gains rates, which top out at 23.8%.3 Therefore, when comparing the yields of bonds and preferreds, we believe they should be analyzed on a post-tax basis for investors holding these instruments in taxable accounts. All else being equal, the after tax-income of a bond paying a 5% coupon is approximately 2.8%, while a preferred paying a 5% dividend yield treated as QDI is approximately 3.8%.
With their unique structure, preferreds can potentially act as an important diversifier for income-oriented portfolios. In the table below, we compare the long-term correlations of preferreds with other major asset classes. Their correlations with all other asset classes included in the chart was less than 0.70 and they demonstrated particularly low correlations with traditional fixed income investments like long-term US treasuries (-0.24) and investment grade corporate bonds (0.17).
Preferred securities can contain a number of unique features, such as being fixed to floating, callable, or convertible. They also are predominately issued by financial institutions, resulting in sector-specific risks.
83% of preferreds are issued at a fixed rate, meaning that dividend payments will not be influenced by rising or falling interest rates.4 Fixed to floating issuances, however, have a specified period during which they pay a pre-determined fixed dividend amount, but after that period expires, the dividend payment can fluctuate based on an interest rate measure such as LIBOR.5 While investors can potentially benefit from this feature if rates rise, the fixed-to-float feature presents a potential risk should rates fall.
Preferred securities can also be issued with call features, similar to bonds. The issuing institution sets a predetermined call value and a date at which they can call and redeem the preferred stock. When interest rates fall, investors are more likely to face call risk, as issuers potentially look to lower their cost of capital by calling the shares and issuing new ones at a lower rate. Some preferreds may have multiple call values and dates.
Preferred stock can be issued with a conversion feature, allowing investors to exchange the preferred for common stock. Currently, approximately 5% of the preferred market is convertible.6 The option to convert to common stock gives investors the opportunity to participate with greater potential upside in bull markets, an environment in which preferred shares may lag common shares. In exchange for the conversion feature, these preferreds tend to pay lower yields than non-convertible preferreds.
Preferreds are overwhelmingly issued by financial institutions, with the sector making up 84% of the US preferred market.7 This is due to the fact that certain preferred issuances could fall under a bank’s Tier 1 capital, which is considered the highest quality of capital under the Basel accords.8 Therefore, banks had strong incentives to issue preferreds. Changes in regulatory classifications of certain preferred securities however, could force banks to reconsider the issuing new preferred securities in the future.
Fit in a Portfolio
Given their historically high yields on both a pre-tax and post-tax basis, preferreds offer the potential to increase a portfolio’s income. In addition, their low correlations with equities and traditional fixed income instruments can make them a useful diversifier in portfolio. Their hybrid equity and bond-like characteristics has led portfolio managers to classify preferreds as fixed income, equities, and alternatives, depending on their preferences. One way to implement a preferred allocation in a portfolio is to replace a portion of one’s less tax efficient high yield debt or one’s lower yielding and tax inefficient investment grade debt.
Investors looking to increase their yield potential from preferred securities should consider the Global X SuperIncome Preferred ETF (SPFF), which invests in 50 of the highest yielding Preferreds in the US and Canada.