Global Fixed Income

Weekly discussion of fixed income market action and what it may mean for investors.

April 25, 2017

Brian Rehling, CFA , Co-Head of Global Fixed Income Strategy

Income Focus—Preferred Stock

  • Many investors looking to increase investment income earning potential may consider preferred stock as a desirable addition to their portfolio.
  • Once you have a full understanding of the risks and potential rewards of preferred stock, you can determine if preferred securities belong in your portfolio. Your investment professional can assist you in that process.

What it may mean for investors

  • We currently recommend that investors hold a neutral weight on the preferred-security sector. Any potential allocation should be based on an investor’s risk tolerance and portfolio objectives.

Income Focus—Preferred Stock

Many investors looking to increase investment income earning potential may consider preferred stock as a desirable addition to their portfolio. While the name may imply that preferred stock has a priority to creditors, in most cases, preferred stock investors are actually subordinate to or behind in priority to holders of a company’s debt. Investors should understand that the increased earning potential of preferred securities comes with increased volatility and risks. Exactly what those risks are may not be readily apparent to some investors. Once you consider the risks and potential rewards, you can determine if preferred securities belong in your portfolio.

Chart 1. S&P Preferred Stock IndexChart 1. S&P Preferred Stock IndexSource: Bloomberg, 4/24/17. Past performance is not a guarantee of future results. The S&P Preferred Stock Index measures the performance of preferred stocks listed in U.S. with a market capitalization of more than $100 million.

In most markets, including the current one, the main attraction for investors in owning preferred securities should not be price appreciation, but rather, income generation. Chart 1 illustrates that over the past five years, preferred securities have experienced little appreciation in prices. In our opinion, from a price valuation perspective, preferred securities appear to be fully valued. However, what is not captured in the price chart of the S&P Preferred Stock Index is the substantial income that can be generated from these securities. A total-return view of the preferred sector shows that the three-year average annual return of the S&P U.S. Preferred Stock Index through April 21, 2017, was 6.5 percent, while the one-year and year-to-date total returns of the index were 6.0 and 5.3 percent, respectively.

Duration—Not Always at It Appears

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. Yet, it is interesting to note that, 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 percent and ended the year at 3.03 percent—an increase of 1.20 percent. The preferred securities sector, while still posted a small loss, was the best-performing taxable fixed income sector in 2013, despite its long-duration profile. The preferred sector experienced its most significant losses in 2007 and 2008 as interest rates plummeted and credit and liquidity concerns dominated investor concerns. While a significant interest-rate move should undoubtedly impact preferred securities, historically changes in the credit environment have had a more powerful impact.

Tax Benefits Can Be an Added Bonus

Preferred securities are generally senior to common stock but subordinate to more senior creditors. For this reason, investors are generally offered higher yields for preferred stock than can be found in similarly-rated bonds. Many investors do not realize that this subordination can provide a tax benefit, as some preferred stock income is taxed as qualified dividend income rather than ordinary income. This favorable tax treatment can offer some investors significant tax savings compared to income that is taxed as ordinary income, such as corporate-bond income.

Not all preferred securities receive qualified dividend income treatment for tax purposes, so it is important for investors to carefully (and fully) review the prospectus of any potential security being considered for purchase to determine income qualification.

What is the Appropriate Allocation to Preferred Securities?

There are a number of features that investors may embrace when seeking to add higher-yielding securities to their portfolio. 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 that investors hold a neutral weight on the preferred-security sector. The percent of a domestic fixed-income portfolio allocated to preferred securities will vary from investor to investor based on risk tolerance and portfolio objectives. Investors that choose to own preferred securities can consider a modest allocation within their domestic investment-grade credit allocation, while taking care to avoid an over-allocation to the sector.

In the current environment, we favor higher-coupon securities and fixed-to-floating rate structures within the preferred sector. Given the higher volatility of the preferred sector, we recommend that exposure be diversified among a variety of issuers, sectors and structures. We strongly recommend that investors consider a professional investment manager to oversee their preferred security 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 can offer significant new pockets of liquidity and additional structures to help optimize value.

Risk Factors

There are special risks associated with investing in preferred securities. Preferred securities are subject to interest rate and credit risks. Interest rate risk is the risk that preferred securities will decline in value because of changes in interest rates. Credit risk is the risk that an issuer will default on payments of interest and principal. 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. Preferred dividends are not guaranteed and are subject to deferral or elimination.

A fixed-to-floating rate security pays a fixed rate for a specific period of time, than a floating rate until the security is called by the issuer. If the fixed-to-floating security is not called at the end of the initial fixed rate period, then the new coupon would float at a pre-defined rate over a floating rate benchmark (typically 3-month LIBOR). Preferred securities are subject to interest rate and credit risks. Interest rate risk is the risk that a security will decline in value because of changes in interest rates. Because preferred securities are long-term instruments, they are subject to a high degree of interest rate risk.

Definitions

An index is unmanaged and not available for direct investment.

The S&P Preferred Stock Index measures the performance of preferred stocks listed in U.S. with a market capitalization of more than $100 million.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII) WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

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