April 21, 2020
Brian Rehling, CFA , Head of Global Fixed Income Strategy
Investment Idea—Preferred Stock
- Significant price declines offer patient investors an opportunity to add income oriented securities to portfolios at attractive levels.
- We believe additional price declines in preferred securities are possible in the near term as the sector is sensitive to the overall market risk appetite.
What it may mean for investors
- We expect income oriented securities to be desirable to investors over the long term as we expect rates to remain at low levels for an extended period of time.
Preferred stocks have long been one of our favored sectors for income oriented investors. Pre-crisis, preferred securities were trading at rather lofty valuations but offered investors potential for income that was difficult to find in other segments of the bond market. We stated multiple times that the primary risk in this sector was market volatility and illiquidity. True to form, we have seen many preferred securities decline meaningfully in price over the last two months as illiquidity and volatility gripped markets.
We continue to believe preferred securities will remain an attractive fixed-income sector to own in what is likely to be an extended low-rate environment. We believe investors who bought the yield rather than the price should continue to experience solid payment profiles absent additional significant negative events. Investors looking to be opportunistic in the current market could look to add preferred securities at current levels. Preferred securities are not without risk, as evidenced by the most recent downturn. Investors participating in this income oriented sector should understand the risks and complexities inherent in many preferred securities.
What are preferred securities?
Investors have used the term “preferred security” as a blanket term to describe any security that typically trades with a $25 par value, has a fixed dividend, and is listed on a major exchange, such as the New York Stock Exchange (NYSE). Today the “preferred security” market encompasses a wide range of structures with meaningful differences that can have a significant impact on individual security valuations and suitability. The securities that investors refer to as “preferred securities” could be either senior in nature (such as a senior unsecured debt instrument) or a deeply subordinated junior security. Preferred securities can be found in both retail ($25 par value) and institutional ($1,000 par value) markets with a wide range of structures.
While the name may imply that preferred stock has a priority to other creditors, in most cases preferred stock investors are actually subordinate to—or behind in priority to—other holders of a company’s debt. In a distressed situation, some preferred securities could stop paying dividends without triggering an issuer default, and in an actual default scenario, senior bond holders would have priority in liquidation. Preferred stock holders are senior to equity holders. Investors should understand that the increased yield potential of preferred securities comes with increased volatility and risks. Exactly what those risks are may not be readily apparent to some investors. Only with a full understanding of the risks and potential rewards can investors determine if preferred securities belong in their portfolios.
In most markets, the main attraction for investors in owning preferred securities should be the potential for income generation—not price appreciation. However, during periods of market volatility, preferred security valuations tend to fall, and patient investors have the opportunity to experience not just attractive yields but also the prospect of price appreciation. In Chart 1, you can see that over the last 15 years, the S&P U.S. Preferred Stock Index has experienced no appreciation in prices; in fact, the price index is actually below its inception price, as some preferred securities were effectively wiped out during the 2008-2009 financial crisis. However, investors who purchased securities during significant price declines would have experienced strong price returns once volatility eased. In our opinion, from a price valuation perspective, preferred securities appear to be relatively cheap on a historical basis.
Still most important for preferred security investors is yield or income generation. What is not captured in the price chart of the S&P U.S. Preferred Stock Index is the income that is generated from these securities. The S&P Preferred Stock Total Return Index in Chart 2 visually shows the impact of yield on an investor’s total return. The yield component of total return is clearly demonstrated in this chart and is the reason we tend to focus on income generation, rather than price return, when considering the attractiveness of preferred securities. With our expectation that interest rates will stay low for an extended period of time, we believe income oriented securities should remain in high demand. Longer term S&P Preferred Stock Total Return Index historically has experienced positive total returns despite the significant recent price decline.
Duration – Not a primary concern
Despite our expectation of low rates, many investors are concerned that preferred securities are very interest-rate sensitive given their potential to remain outstanding for a very long or indefinite period of time. Interestingly, historically significant interest rate movements do not appear to have an outsized impact on preferred securities. In 2013, the year of the “taper tantrum,” 10-year Treasury yields began the year at 1.83% and ended the year at 3.03%—an increase of 1.20%. Preferred securities, while still posting a small loss, were the best performing taxable fixed-income sector of 2013, in spite of the potentially long durations inherent in the sector. (Duration is a measure of a bond’s sensitivity to changes in interest rates.) The preferred sector experienced its most significant losses in 2007 and 2008 as interest rate plummeted and investors had growing concerns about credit and liquidity. While a significant interest rate move would undoubtedly impact preferred securities, changes in the credit environment historically have had a more powerful impact.
Potential tax benefits an added bonus
Some but not all preferred securities are taxed as qualified dividends rather than ordinary income. This favorable tax treatment offers some investors a tax cut over income that is taxed as ordinary income.
Not all preferred securities receive qualified dividend treatment so investors should read the prospectus of any potential security they are considering fully and carefully to determine qualification.
What is the determination of allocation to preferred securities?
There are a number of features that investors may embrace when adding higher yielding securities to their portfolios. These can include longer maturities, lower credit quality, less liquidity, and a loss of structural protections. Preferred securities contain most, if not all, of these qualities. Today’s preferred security market encompasses a wide range of structures with meaningful differences that can have a significant impact on individual security valuations and suitability.
We currently recommend a favorable weight on the preferred-security sector. The percentage of a domestic fixed income portfolio allocated to preferred securities will vary from investor to investor based on risk tolerance and portfolio objectives. Investors who choose to own preferred securities can consider a modest allocation within their U.S. investment-grade credit allocations while taking care to avoid an over-allocation to the sector.
Given the higher volatility of preferred securities, we recommend that exposure to this sector be diversified among a variety of issuers, sub-sectors, and structures. We recommend that investors consider a professional manager to oversee their preferred allocations. Managers have the resources to monitor changing market and regulatory conditions to better optimize a preferred portfolio. In addition, manager access to the $1,000 preferred market offers new pockets of liquidity and additional structures to help optimize value.
Credit analysis is key to investment in the preferred security sector—avoiding those issues that ultimately fail is paramount to maintaining income and avoiding significant losses. We recommend that those investors who lack a deep understanding of the many nuances in the preferred market look to a professional manager for their preferred allocations.
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. All investing involves risks including the possible loss of principal. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. Preferreds securities have special risks associated with investing. Preferred securities are subject to interest rate and credit risks. Preferred securities are generally subordinated to bonds or other debt instruments in an issuer's capital structure, subjecting them to a greater risk of non-payment than more senior securities. In addition, the issue may be callable which may negatively impact the return of the security. There is no guarantee that dividend-paying stocks will return more than the overall stock market. Dividends are not guaranteed and are subject to change or elimination.
S&P Preferred Stock Index measures the performance of preferred stocks listed in U.S. with a market capitalization over $100 million.
S&P U.S. Preferred Stock Total Return Index is designed to measure the total return price performance of the U.S. preferred stock market. Preferred stocks pay dividends at a specified rate and receive preference over common stocks in terms of dividend payments and liquidation of assets.
An index is unmanaged and not available for direct investment.
Investment Grade bonds - A rating that indicates that a bond has a relatively low risk of default. Bond rating firms, such as Standard & Poor's, use different designations consisting of upper- and lower-case letters 'A' and 'B' to identify a bond's credit quality rating. 'AAA' and 'AA' (high credit quality) and 'A' and 'BBB' (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ('BB', 'B', 'CCC', etc.) are considered low credit quality, and are commonly referred to as "junk bonds".
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