Preferred stocks and securities offer higher yields than most traditional fixed income investments, but higher returns typically come with higher risk.
Because they have long (or no) maturity dates, preferred security prices can be volatile. Their higher coupons can help offset potential price declines, but investors should have a long time horizon.
Financial-sector issuers make up most of the preferred securities market.
Looking for higher yields? Preferred securities are one way to potentially boost the income from a fixed income portfolio without having to wander into the sub-investment-grade end of the credit risk spectrum.
This isn’t to say preferred securities aren’t without risk. As with any investment, higher yields generally mean more risk. Preferred securities are subject to many of the same risks as fixed income securities including interest rate, credit, call, liquidity, reinvestment, purchasing power and market/event risk. But we believe economic conditions currently support the case for considering an allocation to preferreds as part of a diversified fixed income portfolio: Global interest rates are low, we believe the future course of long-term rates looks mild and the economy is growing, albeit slowly. So let’s take a closer look.
What’s a preferred security?
Preferred securities can be considered hybrid investments that share characteristics of both stocks and bonds. 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), though preferreds usually don’t carry voting rights. Also like stocks, they usually trade on an exchange.
“Preferred” refers to the order in which investors can expect to be 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. Different kinds of preferred securities—preferred stock, hybrid preferred securities and senior notes—may occupy different places in the payment pecking order between common stocks and bonds.
As far as the bond-like features:
- Coupons: Depending on the type of security, coupon payments could be considered interest or dividend income. Most preferred securities have fixed coupon rates, like a traditional bond, though some have floating rates. Unlike bonds, which typically make coupon payments semiannually, preferred securities tend to pay quarterly. 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.
- Maturity: Preferred securities generally have long maturity dates, ranging from 30 to 60 years, or no maturity date at all (these are known as “perpetual preferred securities”). Most preferreds are callable, allowing the issuer to retire the security at a set price (usually par) on or after a specific date prior to maturity. That is one source of risk, because issuers tend to call a security when interest rates are falling and they can issue new securities at lower yields, exactly the time that investors don’t want to receive their cash back.
- Weaker guarantees: As noted above, most preferred securities rank below the issuer’s bonds in the order of priority for payment. In a bankruptcy, for example, a company’s bondholders would be paid before holders of preferred securities. Due to this “subordination,” an issuer’s preferred security will generally have a lower credit rating than its senior unsecured bonds.
Higher yields in a (still) low yield environment
Another characteristic preferreds share with bonds is that they may have a rating from a credit-rating agency such as Moody’s Investors Service or Standard & Poor’s. In a world of low and even negative bond yields, investment-grade preferred securities can offer attractive yields. As the chart below shows, the BofA Merrill Lynch Fixed Rate Preferred Securities Index, a broad gauge of the investment-grade preferred securities market, has an average yield to worst of 4.4%, above most other investment-grade alternatives.1
Preferred securities have higher yields than most investment-grade alternatives
Source: Barclays and Bloomberg. Data as of 3/29/2016. High-yield corporate is represented by the Barclays U.S. Corporate High-Yield Bond Index; Preferreds are represented by the BofA Merrill Lynch Fixed Rate Preferred Securities Index; Investment-grade corporate is represented by the Barclays U.S. Corporate Bond Index; Agency mortgage-backed is represented by the Barclays U.S. Mortgage Backed Securities Index; Treasuries are represented by the Barclays U.S. Treasury Bond Index; and International ex-USD is represented by the Barclays Global Aggregate ex U.S. Bond Index.
The average coupon rate of the holdings in the BofA Merrill Lynch Fixed Rate Preferred Securities Index is 6.2%. That’s well above the 4.2% average coupon rate of the Barclays U.S. Corporate Bond Index and just below the 6.6% average coupon rate of the Barclays U.S. Corporate High-Yield Bond Index.2 The high-yield bond index is composed of sub-investment-grade issues, which generally carry more credit risk (that is, the risk that the issuer will be unable to make interest or principal payments).
In fact, over the past five years, preferred securities have been one of the best-performing fixed income asset classes. As the chart below illustrates, preferred securities are just below long-term Treasuries in terms of annualized returns, and they’ve been less volatile than high-yield corporate bonds and emerging market bonds.
Risk and return varies by type of fixed income investment
Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. Treasuries (short-term) are represented by the Barclays Short Treasury Index; Treasuries (intermediate-term) are represented by the Barclays U.S. Intermediate Treasury Index; Treasuries (long-term) are represented by the Barclays U.S. Long Treasury Index; U.S. Aggregate is represented by the Barclays U.S. Aggregate Bond Index; Muni bonds are represented by the Barclays Municipal Bond Index; Corporate (investment-grade) is represented by the Barclays U.S. Corporate Bond Index; Corporate (high-yield) is represented by the Barclays U.S. Corporate High-Yield Bond Index; Preferreds are represented by the BofA Merrill Lynch Fixed Rate Preferred Securities Index; EM bonds are represented by the Barclays EM USD Aggregate Bond Index. The chart above compares the risk and return features of the various fixed income indices. Risk is represented by the annualized standard deviation of monthly returns, and return is represented by the average annualized total return from 3/2011 through 2/2016. Returns assume reinvestment of bond principal and interest and are not adjusted for taxes. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
What about a rise in rates?
Preferred securities, like most other fixed income investments, are sensitive to interest rate changes. 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.
How much prices change depends partly on an asset’s duration, a measure of interest rate sensitivity. Assets with longer maturities tend to have longer durations, and the longer the duration, the more sensitive the asset’s price will be to rate changes. Remember that preferreds tend to have very long maturities, or no maturity at all, so they could be in for some volatility if rates rise again.
That said, preferreds’ stock-like qualities also mean they can respond to market factors as well as changes in interest rates. In fact, over the past five years, preferreds have been more correlated with stocks than with bonds.3
So, if interest rates rose and economic growth continued to improve, preferreds might not move much at all. An improving economic outlook could prompt investors to demand less of a risk premium.
(On a separate note: We don’t expect yields on longer-dated Treasuries—which are driven more by growth and inflation concerns than by changes in the federal funds rate—to rise much more if rates go up. Since the Federal Reserve hiked rates by 0.25% in December, the 10-year Treasury yield has actually dropped by 0.5%.4)
High concentration of financial institution issuers
Another thing to keep in mind is that the market for preferred securities is dominated by financial institutions, so sector diversification can be challenging. Preferreds issued by financial institutions make up more than 70% of the BofA Merrill Lynch Fixed Rate Preferred Securities Index (in comparison, financials make up about a third of the investment-grade corporate bond index5).
Given this concentration, the preferred market tends to track financial stocks, as you can see in the chart below. When stock market volatility picked up earlier this year, preferreds also moved, with the average price of the preferred index falling more than 4%. Preferred prices have since rebounded, generally following the path of stocks.6 During periods of market volatility, it’s important to understand that preferred securities may act more like stocks than bonds, and may not give you the diversification benefits that high-quality core fixed income holdings can offer.
Preferred securities may act more like stocks than bonds during periods of market volatility
Source: Bloomberg. Daily data as of 3/30/ 2016.
How to invest?
The preferred stock and securities market is a niche market, and investing in it can occasionally be challenging, in our view. As noted above, there are different kinds of preferred securities, each with its own guarantees and structures.
Because of the market’s relative complexity, we believe investing through an active manager is preferable to investing in preferreds-focused exchange-traded funds that merely track an index. Working with a manager can mean investing in actively managed mutual funds or separately managed accounts that invest in preferreds. Building a portfolio of individual preferred issues yourself is another option, allowing you to find issues that fit your needs. If that seems too daunting, an active manager may be a more appropriate option.
What to do now
We believe preferreds can be a useful complement to investors' core fixed income holdings, due to the higher yields they typically offer. But they do come with unique risks, so make sure these investments match your risk tolerance. We believe preferreds should be considered only by investors with longer investing horizons. A Schwab fixed income specialist can help you navigate this market and figure out what approach makes the most sense for you.
1Yield to worst is the lower of the yield to worst or yield to call. It's the lowest yield an investor will receive, barring default.
2Source: BofA Merrill Lynch and Barclays data, as of 3/31/2016.
3Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated.
4Source:Bloomberg. 10-year Treasury yield change from 12/16/2015 through 4/6/2016.
5Source: Barclays U.S. Corporate Bond Index. Financial institutions represent 31% of the overall index, as of 3/29/ 2016.
6Source: Bloomberg. Daily data as of 3/30/ 2016; 4% drop was from 12/31/2015 through 2/11/2016.
Talk to Us
- Call a bond specialist at Schwab anytime at 877-908-1072.
- Talk to a Schwab Financial Consultant at your local branch.