Where Preferreds Fit in Your Portfolio

Yield potential and relatively high fixed distributions made preferred shares something of a trendy investment with interest rates so low following the financial crisis. But the Federal Reserve is restocking its toolkit and could soon ramp up its hiking pace; the solid August jobs report1 may help set the stage for two more rate increases before year-end. How might investors want to view preferreds and broad, market cap-weighted funds like the Global X U.S. Preferred ETF (PFFD) as the Fed readies its next steps? Take a look at the story below.

Elements that preferreds can bring to a portfolio

It’s worth remembering that preferreds have something of a split personality. They’re bond-like in that they’re issued at a par value, yield bearing, and usually come with fixed distributions. They get credit ratings too. But they’re also equity-like, in that they trade on a stock exchange, fall into the lower portion of a firm’s capital structure, and can have their dividends suspended.

In short, preferreds are unique and can bring more to a portfolio than just yield potential, including the following:

—              Low correlation to U.S. equities and traditional fixed income

Preferreds’ low correlation with equities and more traditional fixed income segments may offer some level of diversification during periods of market volatility. Over the last three and five years, the S&P U.S. Preferred Stock Index had a 50-60% correlation with the Bloomberg Barclays U.S. Aggregate Bond Index and a roughly 30% correlation with the S&P 500 Index.2

—              Common stock dividend stoppers and protective covenants

In case of an economic downturn, some Preferreds’ covenants stop dividends to common stock if the dividend on the preferred stock is suspended. Cumulative preferred stock takes this protection even further by including a provision that stipulates that if any dividend payments are missed, the dividends owed must be paid to cumulative preferred stock holders before other classes of preferred or common holders. (Incidentally, it only takes one hand to count the number of companies that suspended dividend payments during the financial crisis and have yet to resume payments.)

—              Possible tax benefits

After-tax yields on some preferreds often look substantially more attractive than their bond equivalent because the income is often classified as qualified dividend income. One way to implement a preferred allocation would be to replace less tax-efficient high yield debt or lower-yielding and tax-inefficient investment grade debt in a portfolio. Bond coupons are taxed as regular interest income. But dividends from preferreds are regularly classified as qualified dividends, which are taxed as long-term capital gains, i.e., at a lower rate.

—                When rates rise, investors can float

Some investors take a closer look at the adjustable income levels that floating-rate preferreds pay when the Fed tightens—as rates rise, coupon payments would be expected to follow suit. Notably, the duration on floating-rate preferreds is shorter than their fixed-rate counterparts, as payments are based on prevailing rates, i.e., the 3-month ICE LIBOR plus a fixed spread. The investor accepts a lower yield in return for having more stability to their invested capital.

The floating-rate preferreds market is rather small, though, comprising just 3% of the nearly $700 billion US preferred market.3 As a result, investors could flock to fixed-to-floating preferreds, and thus inflate the price of this segment. These issues pay a fixed coupon for a specific period, typically five or ten years, and then switch to a floating rate coupon on a predetermined date. However, their continuous call features may cause many of these securities to behave like the fixed-rate securities.

Current trading dynamics to consider

Preferreds largely trade in $25 or $1,000 par amounts, with pricing typically benchmarked against long-term instruments such as 30-year or long-dated bonds. The $25 par preferreds trade at a dirty price, (i.e., the market price includes the accrued dividend) and $1,000 pars trade clean (i.e., without the dividend).

Recently, demand for $25 pars, and the shorter duration fixed-to-floats in particular, has been strong with issuance down.4 Year to date, total return for $1,000 pars is negative, while that for $25 pars is positive.5

The final word: Life, meet Market

It was back to school for my son this month. The big second grader is now off and running, and wondering whether this homework thing is here to stay. (It is, bud.) One thing that his teachers consistently remind me is that teaching isn’t one size fits all, as no two kids are exactly alike as they go from one rung on the educational ladder to the next.

Similarly, preferreds are unique, with no two the same. They all have their own idiosyncrasies, whether fixed, floating rate, or fixed-to-floating rate, as their covenants will attest. Exposure to preferreds can help balance a portfolio’s rate sensitivity. However, investors should do their homework too, especially with Fed moves possibly tempting them to try to get ahead of interest rate risk.

Related ETF

PFFD: The Global X U.S. Preferred ETF invests in a broad basket of U.S. preferred securities, providing benchmark-like exposure to the asset class. It seeks to provide investment results that correspond generally to the price and yield performance, before fees and expenses, of the ICE BofAML Diversified Core U.S. Preferred Securities Index.