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Preferreds: High Prices May Mean Lower Returns

Key Points
  • Preferred securities prices have posted strong year-to-date total returns, but we don’t think such a strong pace can continue.

  • Average prices are near all-time highs, so room for further price appreciation appears limited and the risk of modest price declines has risen.

  • Preferred securities can still make sense for long-term investors who can weather any short-term price volatility, but we prefer a better entry point for investors looking to add preferreds.

Preferred securities have posted strong total returns this year, but we don’t think the pace can continue in the near term. The prices of preferred securities are, on average, close to their all-time highs, and average coupon rates have been dropping for years. Preferred securities can still generate positive returns over the next six- to 12-months, in our view, but the risk of price declines looks set to grow, especially if bond yields rise.

We think preferred securities can still make sense for investors who have the risk tolerance and investing time horizon to withstand potential price volatility. However, given the relatively high prices today, we wouldn’t encourage more short-term, tactically focused investors to add preferreds.

Preferred securities have high interest rate and credit risk

Preferred securities are a type of hybrid investment that share characteristics of both stocks and bonds. Like common stock, preferred securities can represent an ownership stake in a company, entitling its holder to a share of the profits in the form of coupon payments. In terms of their priority when it comes to claims on dividends, preferreds rank above common stock but below an issuer’s senior unsecured bonds. In addition, for most types of preferred securities, management can defer payments at its discretion if the company runs into a tough period. This can't be done with traditional bonds, short of bankruptcy.

Like bonds, preferred securities have fixed par values and make coupon payments that can be either fixed or floating. However, they tend to have long maturity dates—usually 30 years or more—or no maturity date at all. This means they carry high interest rate risk, or the risk that an asset’s price will fall if interest rates rise. All else being equal, longer maturities tend to be more sensitive to interest rate risk.

Given these characteristics, the performance of preferred securities tends to be influenced both by moves in long-term bond yields and movements in the stock market.

High prices and declining coupons could mean lower returns in the near-term

How are preferreds doing now? The average price of the BofA Merrill Lynch Fixed Rate Preferred Securities Index closed at $105.4 on Sept. 18, only 2% below its all-time high of $107.6, hit in early 2013.

Preferred securities prices have rarely been this high

The BofA Merrill Lynch Fixed Rate Preferred Securities Index is just below its record level.

Source: Bloomberg. Monthly data as of 9/18/2017. Past performance is no guarantee of future results.

The risks of a minor sell-off in the near-term appear to be high. Ten-year Treasuries offer a yield of just 2.2%, and we think they can move modestly higher going forward. Meanwhile, equity prices in the U.S. are at all-time highs.1 Although we still believe the bull market in stocks can continue, we also expect some volatility in the near-term. A rise in long-term Treasury yields or a drop in U.S. stock prices could lead to modest price declines in the preferred securities market.

Meanwhile, the average coupon rate on preferred securities has been falling. With long-term Treasury yields still so low, issuers have been able to retire their higher-coupon issues and replace them with lower-coupon issues. This has led to a steadily declining average coupon rate for years. If prices were to fall, lower coupon payments would mean less income to help offset the price drop.

Preferred coupon rates have fallen sharply over the past four years

Preferred coupons have fallen from more than 7% to 5.9% over the last five years.

Source: Bloomberg. Monthly data as of 8/31/2017.

Minor price declines can still lead to positive total returns for long-term investors

The risk of modest price declines doesn’t mean investors should run for the hills. The high (albeit falling) coupons can still serve as a buffer if prices slip. But given the current starting point, a modest drop in prices would mean returns going forward wouldn’t be as strong.

The first chart in this article showed how, historically, preferred prices have tended to drop after pushing above peaks. The chart below can help illustrate what can happen to returns after prices peak. Not surprisingly, higher prices tend to lead to lower returns over the following 12-month investing horizon.

While prices above $105 have generated the lowest average total returns of any of the price cohorts we track, it’s important to understand that they are still positive. For long-term investors who are looking for higher income, preferred securities can still play a role in a diversified portfolio, as long as you can handle the occasional volatility.

Returns historically have been lower in the short term after prices peaked

The average forward 12-month total return for preferred securities priced $105 and above is just 2.2%, compared with 5.3% for preferreds priced $100-$105 and 9.4% for preferreds priced $95-$100.

Source: Schwab Center for Financial Research and Bloomberg. Forward 12-month total returns of the BofA Merrill Lynch Fixed Rate Preferred Securities Index using monthly data from 4/30/1989 through 8/31/2017. Past performance is no guarantee of future results.

How to invest?

The preferred stock and securities market is a niche market, and investing in it can occasionally be challenging. There are many different kinds of preferred securities, each with its own guarantees and structures, as well as various coupon rates and maturity dates.

Because of the market’s relative complexity, we believe investing through an active manager is preferable to investing in preferred security-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?

Make sure you have a long-term investing horizon when investing in preferred securities. While there can be occasional bouts of volatility and modest price declines, the high coupons that preferred securities offer can help them generate positive total returns over longer investing horizons. And we always think preferreds make sense as a complement to core fixed income holdings, not as a substitute. If you are looking for higher income and have a long investing horizon, a Schwab fixed income specialist can help you navigate this market and figure out what approach makes the most sense for you.

1S&P 500 Index, as of 9/18/2017.

Next Steps

To discuss how this article might affect your investment decisions:

  • Call a bond specialist at Schwab anytime at 877-908-1072.
  • Talk to a Schwab Financial Consultant at your local branch.
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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.

Investing involves risk including loss of principal.

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.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

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 BofA Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of fixed-rate U.S. dollar (USD)-denominated preferred securities issued in the U.S. domestic market.

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