The era of exceptionally low interest rates has been difficult for income-focused investors. When rates are low, generating meaningful returns from your fixed income investments can be tough. The situation has driven some yield-hungry investors to look beyond bonds to alternate sources of income.
Preferred securities—hybrid investments that share certain characteristics of both stocks and bonds—are one such alternative. These securities can carry either investment-grade or sub-investment-grade ratings. But we prefer preferred securities with investment-grade ratings, which tend to offer higher yields than other comparable investment-grade fixed income assets. For example, the average coupon rate of the investment-grade securities in the BofA Merrill Lynch Fixed Rate Preferred Securities Index is 6.2%, compared with 4.3% for the Barclays U.S. Corporate Bond Index.1 So, might preferreds be an attractive alternative?
It’s worth asking, especially now. Even after the Federal Reserve raised interest rates in late 2015, they are still low by historical standards and are likely to remain that way for some time.
Here we’ll take a closer look at how preferred securities work and how they’ve fared in past rising-interest-rate cycles. We’ll also discuss a few considerations to keep in mind when adding them to the income-generating part of a portfolio.
How do preferreds work?
Like a common stock, a preferred security can represent an ownership stake in a company, entitling its holder to a share of the profits (in the form of coupon payments). “Preferred” refers to the order in which investors can expect to get paid. Bondholders typically get first dibs on any coupon payments, followed by holders of preferred securities. Owners of common stock get paid out of what’s left.
Then there are the bond-like features. Preferred securities make coupon payments at either a predetermined fixed- or variable-coupon rate—though there’s no guarantee coupons will always be paid, as we’ll see below. Most have maturities, which tend to be long, though many don’t (these are perpetual preferred securities). They also have a par value—or face value—which is generally the amount promised to an investor when (or if) the securities mature or are repaid.
What are the risks?
There are a few potential cons to keep in mind. For example, preferred securities tend to have:
- Less growth potential than common stocks. Preferred securities don’t grow more valuable if the issuing company expands or becomes more profitable. In fact, they generally don’t rise too far above their par value.
- Weaker guarantees than bonds. Though rare, a company can decide to suspend its dividend payment if it hits a rough patch. This isn’t an option with traditional bonds, short of a default. In the event of a bankruptcy, corporate bond owners are repaid before holders of preferred securities. Preferred securities also tend to be “callable,” meaning they can be retired prior to maturity at a specified price after a specified date.
A look at yields
Such risks are the main reason preferred securities—which, like bonds, generally carry a credit rating—tend to be lower rated than bonds, even if they’re from the same issuer. It’s also why investors demand higher yields.
For example, the BofA Merrill Lynch Fixed Rate Preferred Securities Index, a broad gauge of the investment-grade preferred securities market, has a 4.4% average yield-to-worst (the lowest yield an investor can expect with a callable security).2 That’s higher than most investment-grade bonds, as you’ll see in the chart below.
What happens if rates continue to rise?
Preferred securities, like most other fixed income investments, are sensitive to interest rate changes. After all, the relative attractiveness of a fixed stream of payments can change if yields on other assets rise or fall. Generally, when rates go up, the prices of existing fixed income assets fall (and vice versa), bringing their yields closer to those on securities issued at the new prevailing rate.
What does that mean now, if the Fed continues to raise rates? Although past performance is no guarantee of future results, past cycles offer a few clues. We looked at how investment-grade preferred securities performed during the 24 months following the last three Fed rate-increase cycles—in 1994, 1999 and 2004 (see chart below).
While returns were negative early in the 1994 and 1999 cycles, cumulative total returns turned positive 12 to 14 months after the first rate hike. During the 2004 cycle, prices actually rose, so total returns never turned negative.
In all three cases, total returns were strongly positive within two years’ time. Why? Total returns come from both price changes and coupon payments. Even if preferred securities’ prices slip after a hike, those coupon payments can help drive returns over time.
What to think about before investing
Preferred securities can be an aggressive complement to your core fixed income holdings. But before investing, consider the following:
First of all, given where we are in the interest rate cycle, it may make sense to have a longer time horizon for your preferred securities investments. If the Fed raises rates further, prices could dip, and it may take time for returns to turn positive.
Second, investing in these securities can be complicated. There are many different types of preferred structures, and different securities can have very different characteristics. For example, repayment guarantees can vary. Some offer to make up for any missed dividends, while others don’t. Some offer floating rates that adjust with interest rates.
As a result, it may make sense to focus on actively managed, rather than passive, investment strategies as this complex market responds to any future changes in volatility and interest rates.
1 Data as of 1/8/2016.
2 Yield-to-worst is the lower of the yield-to-maturity or yield-to-call. It’s the lowest yield an investor will receive, barring default.
Call a Schwab Fixed Income Specialist at 877-566-7982 to determine if preferred securities are right for your portfolio.