COLLIN MARTIN: Bond investors are often looking for the highest yields they can find. While we usually caution that higher relative yields do come with greater risks, an allocation to riskier fixed income investments to earn higher yields can make sense as long as it’s part of a well-diversified portfolio. Preferred securities are one way to earn those higher yields.
I’m Collin Martin, and this is Bond Market Today.
Preferred securities are type of hybrid investment that share characteristics of both stocks and bonds. Like bonds, they have fixed par values, they make scheduled coupon payments, and they generally have ratings from rating agencies like Moody’s or Standard and Poor’s. But preferred securities have very long maturity dates--usually thirty years or more--or no maturity dates at all. Preferred securities are often "callable", meaning an issuer can retire them after a certain amount of time has passed at their par value. Like stocks, preferred securities rank relatively low in an issuer’s priority of payment plan, usually below an issuer’s bonds; and the coupon payments the preferreds make are often discretionary--meaning that they can usually suspend the coupon payments without necessarily triggering a default.
Now, even though preferred securities rank below an issuer’s bonds, they rank above an issuer’s stock. So, before a firm can make a common stock dividend payment, it needs to pay its preferred shareholders first, hence the name preferreds.
Now, because of those hybrid qualities, preferred securities come with two key risks: interest rate risk and credit risk. Interest rate risk is the risk that an investment’s value will fall if interest rates rise, and because preferred securities have very long maturity dates or no maturity dates at all, they’re highly sensitive to long-term treasury yields. Credit Risk is the risk that an issuer can’t make timely interest or principal payments. So, because preferred securities rank below an issuer’s bonds, and because their coupon payments may be discretionary, they have relatively high credit risk also.
Now, because of those risks, preferred securities do offer higher relative yields. Now, rather than be tempted by those higher yields, we always think it’s best to invest in preferreds in moderation, and as long as you have a long-term investing horizon, because preferred securities prices can be highly volatile. Preferred securities should never be considered short-term investments.
And finally, preferred securities are very unique and they come with a lot of nuances, so it can be difficult to find an appropriate investment. A Schwab fixed income specialist can help you navigate the market.
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