It’s been a tough year for income-focused investors, as the economic fallout from COVID-19 has helped push yields to historic lows.
When the pickings are so slim, preferred securities could prove an attractive alternative. They offer higher yields than investment-grade corporate bonds, though they tend to come with more risk.
What are preferred securities?
Preferreds are corporate issuances that blend the characteristics of bonds and stocks:
- Like bonds, preferreds make scheduled coupon payments and have par values (typically $25) that are paid back at maturity. They’re usually issued with maturities of 30 years or more—indeed, some never mature—but are generally callable after five or 10 years, meaning the issuer can redeem the shares for a fixed value before maturity. Many shares also carry a credit rating from a recognized rating agency.
- Like stocks, preferreds tend to be more volatile than bonds, and a company can suspend dividend payments on certain types of preferreds without triggering default, just as they can with dividends on common shares. (Note that some preferreds are structured as debt and pay interest rather than dividends, meaning they could, in fact, trigger a default.) Additionally, they’re lower than traditional bonds on an issuer’s priority of payments—but more senior in the payment hierarchy than common stock (hence the “preferred” moniker)—meaning, in the event the issuer is unable to meet all of its liabilities, preferred shareholders will be paid after traditional bondholders but before common stock shareholders.
Because they’re lower in the payment hierarchy, preferreds carry higher credit risk than some corporate bonds and thus offer higher yields to compensate for that risk. That said, if you can find preferreds from an investment-grade issuer, they’re generally less risky than junk bonds but may offer similar yields.
Should you consider preferreds now?
Low interest rates make preferreds particularly attractive now, but their unique attributes could subject them to additional risk in today’s market for two reasons:
1. The Fed could restrict dividends: The Federal Reserve has been flexing its regulatory authority amid the pandemic. As part of its annual stress tests, in June the Fed instructed large banks to suspend stock buybacks and to keep common stock dividends flat in the third quarter to ensure firms had enough capital to keep lending during the pandemic. Preferred dividend payments weren’t affected by the Fed’s actions this summer, but if the economic picture worsens, banks might need to halt capital distributions—limiting common stock dividends first, then preferred dividends if the Fed deems it necessary.
Suspending dividends not only eliminates a predictable income source for investors but can also severely erode a preferred security’s value. For example, during the Great Recession one preferred security suspended dividends for a staggering 18 months, and its share price fell more than 50% as a result.
2. Your securities could be called: With interest rates near rock bottom for many fixed income securities, investors have bid up prices on higher-yielding preferreds. This raises concerns for investors in callable preferreds, which allow issuers to repurchase the securities at par value prior to their maturity date. If you buy a callable security at a premium, be aware that the issuer could buy it back at par, potentially forcing you to realize a loss by buying high and selling low.
How should investors proceed?
There are three moves investors can make to help mitigate these risks:
- Opt for quality: There’s no telling how the next year will shake out, but issuers of higher-rated securities are generally in a better financial position to satisfy their liabilities. You could also invest via an actively managed preferred fund, whose managers may be able to weed out riskier securities.
- Diversify: If the Fed clamps down on bank common stock dividends, preferreds could be next. One way to get ahead of this is by adding preferreds from sectors the Fed doesn’t regulate—such as communications, real estate, and utilities—to your portfolio. Many preferred funds will hold a mix of issuers from multiple sectors.
- Pay attention to prices: If a preferred security is trading above its typical par value of $25, investigate how soon it could be called. Should interest rates stay low for an extended period of time, issuers may choose to call their higher-interest shares early in order to issue newer shares at lower rates. Investing in preferreds via a diversified fund can help reduce this risk.
Preferreds can be a good way to supplement a fixed income portfolio, especially during times of low interest rates. Just be sure your allocation matches your risk tolerance. We generally recommend fixed income investors limit their exposure to riskier assets—including preferreds—to no more than 20% of their overall portfolio.