A primer on investing in preferred securities

A primer on investing in preferred securities

3 minute read

September 2021

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At a time of scarce yields and growing tax challenges, preferred securities may enhance after-tax income and return potential, while broadening diversification with other fixed income investments.

Tax-advantaged income from high-quality issuers

A hybrid of stocks and bonds. Technically a form of equity, preferred securities act a lot like bonds, with a set face value and a predetermined recurring coupon. Because they rank below bonds in a company’s capital structure, preferreds tend to pay higher income rates than similarly rated bonds. In fact, preferreds have historically paid among the highest yields in the investment-grade fixed income universe.

Familiar issuers. Preferreds are issued mostly by large companies in highly regulated industries such as banking, insurance, utilities, telecommunications and real estate. Some examples include Morgan Stanley, Bank of America, UBS, NextEra Energy, Public Storage, JPMorgan Chase, MetLife and Prudential.

Favorable tax treatment. Many preferred securities pay qualified dividend income (QDI), taxed at just 20% for top earners compared with 37% for interest income, plus the 3.8% Medicare surcharge. The combination of high income rates and lower taxes has historically given preferreds an after-tax yield advantage relative to other fixed income options.

Benefit of active management: full access to a global market

Broader investment universe may provide more yield and total return. Preferred securities are offered in two markets: $25 par securities traded on stock exchanges and $1000 par securities traded over the counter (OTC), typically reserved for institutional investors. Institutionally traded OTC securities make up 85% of the $1.2 trillion global preferred market but can be difficult for individual investors to access. Moreover, the retail exchange-traded market has been slowly shrinking as more companies choose to issue new securities in the OTC market.

Fund managers typically invest in a portfolio consisting of securities from both the retail and institutional markets, offering the potential for:

Better returns: The OTC market has outperformed the $25 par retail market by 1.3% annually since 1997.
Higher yields: Certain geographies and types of securities may offer above-average income rates.
Reduced interest-rate sensitivity: Nearly all securities traded in the OTC market feature rate resets, often resulting in low durations.

Attractive diversification benefits

Preferred securities may offer a low correlation of returns with other areas of the stock and bond markets. Low-correlated assets tend to behave differently within a given market environment and may help reduce volatility when combined in a broad portfolio. Over the last ten years, adding preferred securities to a broad fixed-income portfolio has been shown to increase return while either decreasing risk or keeping risk profiles relatively stable.

Investors interested in obtaining access to preferreds should note that these securities typically account for very small portions of large bond funds, including ETFs that focus on bonds.

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