Preferred Securities: Higher Yields, Different Risks
- Preferred securities may be appealing to aggressive investors looking for higher yields in a low-interest-rate environment.
- Preferred securities have very distinct characteristics, with both stock-like and bond-like qualities.
- Before you invest, it's important to know the details and terms of particular securities.
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Preferred securities are a type of investment that generally offer higher yields than traditional fixed income securities such as US Treasuries or investment-grade bonds. However, the higher yields come with different risks.
Preferred securities are an investment choice sometimes considered by investors seeking higher income. They were also one of the hardest-hit investments during the 2008 credit crisis. What should you be aware of now to decide whether preferred securities might be the right investment for you for a more-aggressive part of your income portfolio?
What are preferred securities?
Preferred securities are "hybrid" investments, sharing characteristics of both stocks and bonds. (Technically, preferred securities are a subset of hybrids. However, in recent years, the term "preferred security" has been used as a blanket term to encompass anything from $25 par senior debt down to traditional preferred stock). Like stocks, they're generally paid after a company's bonds. Like bonds, however, they usually make regular fixed payments and have a par value that can rise or fall, but is generally the amount promised to an investor when (or if) the securities mature or are repaid.
For this discussion, we'll consider preferred securities with a par value of $25 and that, in an issuer's capital structure, rank anywhere from just above common stock to as high as senior unsecured debt.
On the positive side, preferreds generally provide higher yields than many alternatives—though there are good reasons investors demand the higher yields:
- Less growth potential. Preferred securities have fixed par value, like bonds, and tend not to increase in value as common stock may if a company grows. While some preferreds represent an ownership interest, the interest is only in fixed payments, not a growing earnings stream. So the price generally doesn't appreciate much above the fixed par amount.
- Weaker guarantees. Preferred securities don't provide the same guarantees of interest payments and payment at maturity as bonds. In bankruptcy, for example, corporate bond owners are paid before holders of preferred securities. In addition, for most types of preferred securities, management can defer payments at its discretion, if the company runs into a tough period. This can't be done with traditional bonds, short of bankruptcy.
Deferrals of payments don't happen often—partly because, if they did, they'd limit the appeal to investors, of course, but also because a company isn't permitted to pay dividends on common stock while deferring payments on any outstanding preferred securities. In other words, payments on preferred securities must come before payments to common stock; hence the name "preferred."
Like bonds, but unlike common stocks, preferred shares generally carry a credit rating from a recognized rating agency. It's worth noting that a company's preferred securities will usually have a lower rating than the firm's individual bonds.
Types of preferred securities
There are several varieties of preferred securities and the terms used to describe them can be complex. Here are the primary types, beginning with those that have the weakest guarantees:
Preferred stock can be considered the most "traditional" type of preferred security, representing ownership in the issuing company. Unlike an issuer's common stock, preferred stock has a fixed par value. Dividends may be suspended at any time and are not cumulative, meaning they don't need to be paid back. As equity securities, the coupon payments of some of these preferreds may receive advantageous tax treatment such as eligibility for qualified dividend income treatment. This is one reason many individual investors have chosen preferred stock, historically; however, it's important to read the prospectus to understand whether the payments on any shares that you own are taxed at the qualified rate.
Hybrid preferred securities are next in line. In the firm's priority of payment scheme, hybrid preferreds generally rank below the issuer's senior unsecured debt, but above preferred stock. Examples of hybrids include capital trust securities and junior subordinated debentures. The interest payments can be deferred, and can be either cumulative or non-cumulative. If payments are deferred for cumulative preferred shares, the coupons accumulate and must be paid back later, short of bankruptcy or default. This adds a bit of extra protection for investors, as well as incentive for the issuing companies to keep making payments, since they know they'll have to pay them eventually.
"Non-cumulative" means that if payments are deferred, they don't accumulate and won't be paid back later. This is a particularly unattractive feature, warranting higher yields for investors. Don't purchase non-cumulative shares unless you understand the risk of deferral and receive a higher yield than you'd receive from a traditional cumulative preferred share. Also keep in mind that deferred payments from hybrid preferreds can generate a "phantom" income tax, which makes the holder liable for income not yet received. Hybrid preferreds tend to pay interest, not dividends. They usually have fixed maturity dates (though generally long), compared to preferred stock, which is perpetual by nature.
Baby bonds, or senior notes, are just that: senior unsecured obligations of the issuer. Like bonds, they pay interest, and any missed payments constitute a default. Unlike bonds, they usually have a par value of $25 instead of $1,000, and they usually trade on an exchange. Despite their $25 par value and association with other preferred securities, these securities offer the same guarantees that senior unsecured bonds offer.
Typical Preferred Security Structures
Source: Schwab Center for Financial Research
Why do companies issue preferred securities?
Companies generally issue preferred securities for flexibility. The primary issuers tend to be financial firms, such as banks or real estate companies, which need easy access to debt markets to operate. But other companies, such as utilities and industrial companies, often issue preferred securities as well. Preferred securities provide these companies with flexibility as an extra financing tool in addition to common stock and more-traditional corporate bonds.
The capital structure of the largest US banks, which are among the primary issuers of preferred shares, is as follows (note that preferreds are sandwiched below traditional bonds and above common stock):
- Common stock (lowest in capital structure)
- Non-cumulative preferred stock
- Cumulative preferred stock
- Hybrid preferreds
- Subordinated debt
- Senior debt, including baby bonds (highest in capital structure).
Banks, which have strict regulatory requirements, are also able to use preferred securities as a source of capital "cushion" between their bonds and common stock. Bank regulations require certain levels of capital reserves, and preferreds can help meet that objective. The degree of capital treatment varies depending on the type of preferred security.
Preferreds do come with additional risks
Higher yields may be appealing, but they almost always come with the additional risks described below. However, lower yields can also be risky—in terms of maintaining purchasing power, meeting living expenses and so on. So there are tradeoffs. Which risks are most important to you?
Sector concentration in banks and finance companies. One issue to consider when choosing preferreds is how they tend to be dominated by financial companies and banks (although real-estate firms can be heavy issuers as well). If you buy individual preferreds, this can lead to inadvertently concentrating your portfolio in specific financial firms as well as in the financial sector as a whole. We suggest limiting exposure to any single issuer to no more than 10% of your portfolio.
Lower credit ratings than the issuer's bonds. An issuer's preferred securities will usually have a lower rating than the firm's senior, unsecured bonds. Also, preferred securities are often compared to sub-investment grade, or high-yield, bonds, given the higher income opportunities. But remember, high-yield bonds, by definition, carry speculative-grade ratings, so they do come with credit risk. Investors who research carefully can still find preferred shares from investment-grade companies, thus providing higher credit quality than junk bonds.
Long duration and interest-rate risk if interest rates increase. Preferred securities usually have long maturities—often 30 years or longer—or even no maturity date at all, meaning they can remain outstanding in perpetuity. They generally are "callable," meaning they can be retired prior to maturity at a specified price after a specified date. But the option of the issuer to call is just that—an option. Despite their callable nature, preferred securities should be viewed as long-term investments, and that means they are generally more sensitive to interest-rate risk if rates rise. If rates do rise, the price of your preferreds may fall, and fall further than shorter-term bonds, all else being equal. One final consideration is that certain types of preferred securities may be less-liquid than other securities issued by the same firms.
Overall, investors with higher appetite for credit risk may consider allocating up to 20% of their total strategic allocation to fixed income to more aggressive fixed-income types, in combination. This more-opportunistic allocation could include preferred securities, high-yield bonds, emerging-market bonds or other sectors with greater credit or interest-rate risk.
Again, preferred securities may not be appropriate for all investors. Those who do choose them should learn about some of the risks and use them strategically as a higher-risk part of their income portfolio.
Find out more about individual preferred securities
Finding good information about preferred securities can be difficult, and there are many details to understand before investing. The best source of information will always be a security's prospectus, which you can obtain from a Schwab fixed income specialist, or from data repositories available online. Schwab clients can access our Preferred Stock Screener.
Don't just screen for the highest yields—also screen based on attributes such as credit rating, and then augment it with more information about the issuing company, the security listed, specific characteristics of the preferred shares (whether they're cumulative or non-cumulative, for example, which is often listed in the security description) as well as call dates and other details.
If you'd like a diversified solution without too much exposure to any single preferred stock or issuer, consider preferred-stock exchange-traded funds (ETFs). Clients can search for funds that include the words "preferred" using our ETF Screener.
Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Investment value will fluctuate, and shares, when redeemed, may be worth more or less than original cost.
Some specialized exchange-traded funds can be subject to additional market risks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.
Past performance is no guarantee of future results.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Potential share price movements of long-term bond funds cause greater risk to principal than with shorter-term funds.
This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. All expressions of opinion are subject to change without notice in reaction to shifting market conditions.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.
Diversification does not eliminate the risk of investment losses.
Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.
International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.
Preferred stocks: (1) generally have lower credit ratings than a firm's individual bonds; (2) generally have a lower claim to assets than a firm's individual bonds; (3) often have higher yields than a firm's individual bonds due to these risk characteristics; (4) are often callable, meaning the issuing company may redeem the stock at a certain price after a certain date. Please call a fixed income specialist at 800-626-4600 to obtain call information before investing in preferred stocks.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.