Download the Schwab app from iTunes®Close

Preferred Securities’ Higher Yields May Attract Income-Seeking Investors

Key Points
  • Preferred securities are beginning to look more attractive for investors looking for higher yields in the current low-yield environment.

  • Potential price declines are possible if the economic outlook deteriorates further due to COVID-19. We expect volatility to remain elevated.

  • We suggest that those considering preferred securities today have a long-term investing horizon, and focus on higher credit ratings and diversification.

Preferred securities are beginning to looking more attractive lately, especially for investors looking for higher income, such as those in or nearing retirement.

We expect volatility to remain elevated, however, and additional price declines are possible, as the ultimate economic impact of COVID-19 remains uncertain. We believe it’s too early to say the worst is behind us, and prices may fall lower if the economic outlook deteriorates further. If you’re considering preferred securities today, your focus should be on the higher yields they offer, not necessarily on near-term price appreciation. As always, we suggest investors considering preferred securities have a long investing time horizon to ride out the likely ups and downs.

What are preferred securities?

Preferred securities are a type of hybrid investment that shares the characteristics of both stocks and bonds.

Like bonds, preferred securities have fixed par values and make scheduled coupon payments throughout the year. Preferreds often make quarterly payments, instead of semiannual payments like traditional bonds do. They are usually issued with maturities of 30 years or more, or they may be perpetual, meaning they have no maturity date at all. Many preferred securities are rated by major credit rating agencies such as Standard & Poor’s or Moody’s Investors Service.

Like stocks, however, preferreds rank very low on an issuer’s priority of payments, for example in the case of bankruptcy. They rank above an issuer’s common stock—hence the name “preferred”—but they generally rank below an issuer’s traditional bonds.

Preferred security coupon payments are often discretionary, like a common stock dividend. That means they can be suspended without triggering a default, unlike a missed payment on a traditional bond. A benefit of many preferred securities—specifically those of preferred stock—is that the coupon payments may receive advantageous tax treatment, such as eligibility for qualified dividend income treatment. Finally, deferred coupon payments can be either cumulative or non-cumulative. If payments are deferred for cumulative preferred shares, the coupons accumulate and must be paid back later, short of bankruptcy or default.

Because of these complex characteristics and increased risks, the yields on preferred securities tend to be higher than other fixed income investments. But those risks also mean prices can be volatile and subject to steep declines like we witnessed in the first quarter of 2020.

Preferred securities prices dropped in the first quarter

The ICE BofAML Fixed Rate Preferred Securities Index lost 8.9% in the first quarter, but that only tells part of the story.

At its trough, the index was down 22.7% for the year, after a more than 11% plunge on March 18. Preferred securities prices, and the value of the index, have since recovered some of those losses, but are still well off the recent highs.

The value of the index plunged by more than 11% in just one day

Source: Bloomberg, using daily data as of 03/31/2020. Past performance is no guarantee of future results.

 

We believe there a few reasons why returns may have been so poor in the first quarter, and why the plunge happened so quickly.

  1. Liquidity. The preferred securities market is small. It’s smaller than both the investment-grade and high-yield corporate bond markets. As a result, when the volume of preferred securities trades increases, prices may fluctuate more than usual.

    In the days leading up to and including March 18, most of the large preferred securities exchange-traded funds (ETFs) suffered large outflows, meaning investors were generally pulling their money out of these investments. Given the rather illiquid nature of the preferred securities market, this selling pressure likely helped exacerbate the price declines.

     
  2. A rise in long-term Treasury yields. This is where things get tricky. Since preferred securities share characteristics of both stocks and bonds, they tend to behave like both. In addition to sharp stock declines during the week of March 16, long-term Treasury yields had also risen.

    Because prices and yields tend to move in opposite directions, a rise in yields can pull preferred securities prices lower. And since preferred securities have long maturity dates, or no maturity dates at all, their yields tend to track those of long-term Treasury yields. Since the plunge in preferred securities prices during the week of March 16, long-term Treasury yields have declined, helping pull up preferred securities prices as well.

     
  3. Credit concerns. As with any income-paying corporate investment, the strength of the issuer matters. Given the spread of COVID-19 and the measures taken to stem the spread further, corporate earnings are likely to fall sharply and the U.S. is likely to enter a recession.

 

Unlike traditional bonds whose interest payments are guaranteed by the issuer (barring a default), many preferred securities income payments are discretionary, meaning the issuer can suspend them without triggering a default if it needs to save cash. This was likely an additional factor pulling prices lower.

Yields have risen due to the drop in prices

We believe that the price declines have presented investors a relatively attractive opportunity to enter the preferred securities market—the yield-to-worst of the ICE BofAML Fixed Rate Preferred Securities Index is now 5.7%. We believe volatility will remain elevated and further price declines are possible, however.

Over the past 20 years, prices have rarely been lower than they are today. Aside from late 2007 through 2009, during the global financial crisis, the average price of the index has rarely been below $95. After falling as low as $81 on March 18, prices have rebounded sharply, closing at $95.5 on March 31.

The chart below also illustrates how prices plunged to extreme depths during the financial crisis, but we’re not expecting a repeat of that experience. During the financial crisis, some large U.S. financial institutions actually went bankrupt, and even some of those that survived temporarily suspended their dividends. There are still some preferred securities outstanding today whose coupon payments were suspended during the crisis, and they’ve yet to be reinstated!

Aside from the financial crisis, prices have rarely been lower over the last 20 years

Source: Bloomberg, as of 3/31/2020. Past performance is no guarantee of future results.

 

We don’t believe a repeat of the financial crisis is likely because most large financial institutions appear to be better positioned to weather an economic downturn this time around, allowing them to remain current on their preferred securities dividends. Financial institutions make up more than half of the preferred securities universe, so the strength of banking issuers is paramount when evaluating the prospects of the broad preferred securities market.

U.S. bank balance sheets are generally in good shape

Source: Federal Reserve Bank of New York, using quarterly data as of 4Q19. The Common Equity Tier 1 Ratio is calculated as common equity tier 1 capital divided by risk-weighted assets.

Due to tighter regulations over the last decade, large bank balance sheets are significantly stronger than they were compared to pre-crisis periods as the chart above illustrates. The average common equity tier 1 ratio, which is one measure of a bank’s financial strength, is significantly higher today. And according to the Federal Reserve’s 2019 annual stress test, even in a severely adverse scenario, capital ratios would still likely be higher than pre-crisis (non-stressed) levels. In short, bank balance sheets are strong.

What to do now

Preferred securities look more attractive today given the lower prices and higher yields compared to the past few years. Most importantly, they should always be considered long-term, aggressive investments. Here are a few things to consider:

  1. Diversify. Whether it’s through owning individual preferred securities, or by investing through a mutual fund or ETF, having exposure to multiple issues and issuers should help if the economic outlook deteriorates further. Holding one or two individual preferred securities would likely leave you more exposed to a company-specific issue that could result to a preferred security dividend suspension.
     
  2. Consider a professional manager. The preferred securities market is complex and has many nuances. Having a professional manager—either through a mutual fund, ETF, or separately managed account—deciding what to hold (and what not to hold) might make more sense for many investors than a passive, index-tracking approach.  
     
  3. Credit ratings matter. We believe that most large financial institutions should remain current on the preferred securities coupon payments, but that doesn’t mean all preferred issues will be able to maintain those coupon payments. Over the past few weeks, a few non-rated preferred securities have already announced dividend suspensions, and that trend may continue. We believe issues with higher credit ratings (investment-grade or the upper rungs of high-yield) are less likely to suspend dividends than those securities that are not rated.
     
  4. Focus on income, not near-term price appreciation. Given the threat of COVID-19, we don’t expect preferred securities prices to rise much, if at all, in the near-term. For now, focus on the higher yields they offer, but be prepared for additional price fluctuations going forward.

What You Can Do Next

How to Put Your Financial Affairs in Order
Market Volatility in Retirement: What if You Haven’t Prepared?

Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. For more information on indexes please see www.schwab.com/indexdefinitions.

The ICE BofA Merrill Lynch (ICE BofAML) Fixed Rate Preferred Securities Index measures the performance of fixed-rate U.S. dollar-denominated, high-yield exchange-traded preferred securities issued in the U.S. domestic market.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets. Investments in managed accounts should be considered in view of a larger, more diversified investment portfolio.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Preferred securities are often callable, meaning the issuing company may redeem the security at a certain price after a certain date. Such call features may affect yield. Preferred securities generally have lower credit ratings and a lower claim to assets than the issuer's individual bonds. Like bonds, prices of preferred securities tend to move inversely with interest rates, so they are subject to increased loss of principal during periods of rising interest rates. Investment value will fluctuate, and preferred securities, when sold before maturity, may be worth more or less than original cost. Preferred securities are subject to various other risks including changes in interest rates and credit quality, default risks, market valuations, liquidity, prepayments, early redemption, deferral risk, corporate events, tax ramifications, and other factors.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

(0420-0YAW)

Thumbs up / down votes are submitted voluntarily by readers and are not meant to suggest the future performance or suitability of any account type, product or service for any particular reader and may not be representative of the experience of other readers. When displayed, thumbs up / down vote counts represent whether people found the content helpful or not helpful and are not intended as a testimonial. Any written feedback or comments collected on this page will not be published. Charles Schwab & Co., Inc. may in its sole discretion re-set the vote count to zero, remove votes appearing to be generated by robots or scripts, or remove the modules used to collect feedback and votes.