Preferred Securities: Are They Attractive Now? (2024)

Preferred securities are a type of hybrid investment that have characteristics of both stocks and bonds. Like bonds, they generally have fixed par values and have scheduled coupon payments. Like stocks, preferreds tend to rank very low in an issuer's capital structure—usually below traditional bonds but above a corporation's common stock. Importantly, they tend to have very long maturities, or no maturities at all (although they can usually be redeemed at the issuer's discretion after a certain amount of time has passed), which was a key driver of their poor performance last year.

Given their long maturities, preferreds are highly sensitive to changing interest rates and bond yields. With last year's surge in Treasury yields, preferred prices plunged through the first 10 months of the year. Total returns have since bounced back a bit given the decline in long-term Treasury yields since last October.

Although we don't expect the total returns to continue at such a high rate through the rest of the year, the outlook is more positive today given the starting point of higher yields.

"Focus on quality" remains a key theme for fixed income investors this year. With that outlook, investors looking for higher yields but not willing to take outsized risks should consider investment-grade corporate bonds rather than preferred securities today. For investors who are willing to take additional risks to earn higher yields, we suggest preferred securities rather than high-yield corporate bonds.

The average yield-to-maturity of the ICE BofA Fixed Rate Preferred Securities Index is roughly 6.9%. That might seem attractive on the surface, but it's not much of an advantage over the 5.8% yield of the Bloomberg U.S. Corporate "BBB" Bond Index. The average credit rating of that preferred security index in the mid-"BBB" area, so comparing yields to BBB rated corporate bonds provides a more apples-to-apples comparison.

That 1.1% yield advantage that preferreds offer relative to similarly rated corporate is relatively low considering it averaged roughly 2% from 2010 through 2019. Given that relatively small yield advantage, more conservative to moderate investors should instead consider investment-grade corporate bonds and the more than 5% average yields they offer, rather than reaching for yield with preferreds today.

As we move down the risk spectrum, however, we prefer preferred securities over high-yield bonds. While high-yield bonds do offer a yield advantage over preferreds—the average yield of the Bloomberg U.S. High-Yield Bond Index is close to 9%—we see a greater risk of price declines with high-yield bonds as the year progresses.

The average spread (or risk premium) that high-yield bonds offer is relatively low today, despite a relatively risky economic outlook. As the yield curve remains inverted and financial conditions tighten, we expect the speculative-grade corporate bond default rate to continue rising from its recent lows. That should pull high-yield bond prices lower over time.

We see less room for preferred security prices to fall, however. The risk of dividend suspension for investment-grade rated preferreds issued by a large financial institution appears low, as most banks appear well-capitalized with strong balance sheets. The average price of the preferred index has rarely been lower, and while it is up sharply over the last few months, we believe a key driver of last year's decline was the rise in long-term yields. Long-term yields could drift higher from here, but upside appears limited. This could help keep preferred prices supported.

Many preferred stocks pay qualified dividends that are subject to lower tax rates than traditional interest income. Investors considering preferreds relative to other investments should always consider what type of account they'll be held in—taxable or tax-advantaged—and if held in taxable accounts, the after-tax yield.

Not all preferred stocks or securities pay qualified dividends—some pay interest—so it's important to know what you own and what the tax consequences are. Qualified dividends are generally taxed at 0%, 15%, or 20% rates, depending on income limits. Those lower rates can be an advantage for investors in high tax brackets.

The chart below compares the yields of a number of fixed income investments with varying degrees of risk. The municipal bond index shown below holds investment-grade rated munis, but the average credit ratings tend to be higher than the holdings in the investment-grade corporate bond index. The yields on the left illustrate the average pre-tax yields of the investments, while the yields on the right reflect the after-tax yields for investors in the top tax bracket. Since the qualified dividend rates don't line up with the traditional tax brackets, we chose to only show the yields in the highest tax bracket for the sake of simplicity.

There are different tax assumptions for each investment in the "37% Tax Rate" side of the chart:

• High-yield and investment-grade corporates assume a 37% federal tax, 5% average state tax, and the 3.8% ACA tax.
• Preferred securities assume a 20% qualified dividend tax and the 3.8% ACA tax.
• Municipal bonds assume zero taxes.

For investors in the highest tax brackets, preferreds may offer higher after-tax yields than high-yield corporate bonds if all of the preferred dividends are qualified.

Over the last four cycles, total returns declined a bit leading into that last Fed rate hike, but then performance improved once the Fed hit its peak. Despite those declines, we don't suggest investors try to time the market and wait for better entry point since we don't know if that will present itself. What we do know is that low prices and high yields present an attractive opportunity for those who may have been waiting to earn more income. Past performance is no guarantee of future results of course, but total returns were positive in the 12 months following the peak of each of the last four rate hike cycles.

This supports the case for investors willing to take a bit more risk to consider preferreds today. What this chart doesn't show, however, is how preferreds perform once a recession hits. During the last two recessions, preferred prices fell sharply, although the 2020 plunge was recovered quickly.

Investors willing to take some risk for higher yields should consider preferreds, but investors with more conservative to moderate risk tolerances might want to consider investment-grade corporate bonds that offer average yields near 5% with less risk than preferreds. For those considering preferreds, we always suggest that they be considered long-term holdings given their long maturities.

There are a number of ways to invest in preferred securities. Schwab clients can use the Preferred Shares Screener when looking for individual preferreds, or you can explore funds on the ETF or mutual fund pages; preferred funds can be found under the Morningstar category of "Preferred Stock." You can also consider a separately managed account.