Preferred securities are a type of investment that offers higher yields in exchange for increased risk. Interest rate risk—or the risk that the price of an investment will fall as interest rates rise—is elevated for preferred securities because they have long maturities, or in many cases no maturity at all.
But not all preferred securities are created equal. Some have fixed coupon rates, others have floating coupon rates, and some have what are known as “variable” coupon rates—they start out as fixed, but become floating after a certain period of time has passed. With interest rates still rising modestly, variable-rate preferred securities may help to limit some of the potential price declines that generally come with that rise. But the decision between fixed and variable-rate preferreds isn’t as simple as identifying the interest rate trend and coupon characteristics—in the end, working with an active manager may help.
What are preferred securities?
Preferred securities are a type of hybrid security that shares characteristics of stocks and bonds. Like bonds, they generally have fixed par values and make coupon payments throughout the year. Unlike traditional bonds, preferred securities usually make quarterly, not semiannual, income payments.
Like stocks, preferred securities rank relatively low in an issuer’s priority of payment scheme, and coupon payments are usually discretionary. However, preferred securities rank above an issuer’s common stock. So in order for the issuer to make a dividend payment to common stockholders, it first needs to make payments to its preferred shareholders—hence the name “preferred.”
Fixed, floating and variable-rate preferreds
Fixed-rate preferred securities are fairly straightforward—they are designed to pay a fixed coupon rate for a set period of time, usually 30 years or longer, although many can remain outstanding in perpetuity. With floating-rate preferreds, a floating coupon rate is based on a short-term benchmark, such as the three-month London Interbank Offered Rate (LIBOR), plus a spread.
Variable-rate, or “fixed-to-float,” securities are a hybrid. At issuance, the coupon rate is fixed. But after a stated amount of time—usually five or 10 years—the coupon switches to a “floating” coupon rate.
Although most floating coupon rates are benchmarked to three-month LIBOR, that reference rate is widely expected to be retired by the end of 2021. Alternative rates have been proposed, like the Secured Overnight Financing Rate, or SOFR, but have not yet been implemented. We do think this poses a risk for the market in the future, as many outstanding issues may be benchmarked to a reference rate that no longer exists, but LIBOR rates continue to function for now. Ultimately, we think the reference rate used in the future will likely be correlated with the federal funds rate, just like three-month LIBOR is today, so any outlook for floating coupon rates should be considered along with the monetary policy outlook.
Higher coupon rates: now or later?
Fixed-rate preferred securities tend to offer higher coupon payments than variable-rate preferred securities. That’s because a fixed-to-float issue is generally able to offer a lower fixed coupon rate today in exchange for the possibility of earning higher coupon payments down the road if short-term interest rates rise, as they have during the past few years.
We used two preferred securities indexes to compare and contrast the two approaches: the ICE BofAML Core Plus Fixed Rate Preferred Securities Indexfor fixed-rate preferreds, and the Wells Fargo Hybrid and Preferred Securities Floating- and Variable-Rate Index for variable-rate preferreds.
The average coupon rate of the underlying holdings of the fixed-rate preferred index is currently 6.3%, compared with just 5.7% for the underlying holdings of the variable-rate index, a difference of about 60 basis points, or six tenths of a percent1 As mentioned earlier, investors in variable-rate preferreds generally sacrifice higher income payments today for the potential benefit if short-term interest rates rise later.
Estimating the breakeven point
How high do short-term interest rates need to rise for the coupons on variable-rate preferreds to catch up with their fixed-rate counterparts? It’s tough to give exact numbers because the composition of a preferred securities index or fund is constantly changing—and each preferred switches from fixed–to-float on different dates—but we can provide some guidance here.
As mentioned above, the average coupon rate of underlying holdings of the variable-rate preferred index is about 5.7%—but most of those coupons are still paying the “fixed” part of the “fixed-to-float” coupon. If they were to suddenly float, that average coupon rate would likely rise to about 5.9%, given today’s three-month LIBOR rate of 2.37% plus the average spreads for the individual holdings. That still puts the average coupon rate about 40 basis points below their fixed-rate counterparts. In other words, three-month LIBOR would need to rise by roughly 40 basis points for the two types of preferreds to offer similar coupon rates once the coupon switch occurs.
What’s your interest rate outlook?
As LIBOR is highly correlated to the federal funds rate, monetary policy expectations should play some sort of role in the decision to invest in something with a variable or floating coupon rate. We expect the Fed to raise rates at least two more times this year, which would lead to an increase of at least 50 basis points in the federal funds rate. And according to median projections from the Federal Open Markets Committee, the federal funds rate could rise to 3.4% by the end of 2020.
However, it’s not as easy as extrapolating where short-term rates will be in a few years and assuming the average coupon rates will move in lockstep. Each preferred security is different, with different floating coupon rate spreads and different schedules for when the rates switch from fixed to floating. For example, given the underlying holdings of the variable-rate index, roughly 19% of the holdings are already floating, while another 19% will switch to float in the next three years. The remaining 62% of the holdings won’t float for three years or more, meaning short-term interest rate movements over the next few years may have less of an impact.
Lately, variable-rate preferreds have generally outperformed their fixed-rate counterparts. Considering that 19% of the holdings are already floating, that’s helped limit the downside in their prices. Since the Fed’s current rate-hike cycle began in December 2015, the Wells Fargo Hybrid and Preferred Securities Floating- and Variable-Rate Index has posted a total return of 16%, compared with just 11% for the ICE BofAML Core Plus Fixed-Rate Preferred Securities Index. We also think this is a nice reminder that fixed income investments can still generate positive total returns even when interest rates are rising.
Fixed-to-float preferreds have outperformed fixed-rate preferreds lately
Source: Schwab Center for Financial Research with data from Morningstar, Inc. Cumulative total returns of the ICE BofAML Core Plus Fixed-Rate Preferred Securities Index and the Wells Fargo Hybrid and Preferred Securities Floating- and Variable-Rate Index. Total returns from November 30, 2015 through April 30, 2018. Returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.
How to invest?
The preferred stock and securities market is a niche market—and investing in fixed-to-float preferreds is even more niche. Investing in preferreds can be a daunting task, given the various types of preferreds, each with their own individual characteristics.
Whether you’re interested in fixed-rate preferreds or variable-rate preferreds, we believe investing through an active manager has many benefits compared to investing in preferred security-focused ETFs 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. But there’s also an added cost involved—active managers tend to charge higher fees than a passive, index-tracking approach.
As illustrated above, even within the fixed-to-float universe, each individual issue has its own schedule of when it will switch from fixed to float. Depending on where both short- and long-term interest rates are heading, a preferred that switches to a floating coupon in one year will likely react to market conditions very differently from an issue whose coupon switches to floating in five years. An active manager can evaluate each issue individually and make an informed decision about what to own and not to own.
What to do now?
Consider fixed-to-float preferred securities in addition to traditional fixed-rate preferreds. While they each have their own characteristics that can offer benefits during various interest rate environments, fixed-to-float preferreds can help provide rising coupon payments down the road as short-term interest rates continue to rise (as we expect they will), and may also help limit the potential price declines as interest rates rise. But more importantly, consider an active approach where a manager can actually evaluate the preferred security market and make an informed decision about which securities to invest in.
1As of 5/7/2018
What You Can Do Next
- Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
- Explore Schwab’s views on additional fixed income topics in Bond Insights.