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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.
Market developments at Credit Suisse
The government-backed deal for UBS to acquire Credit Suisse will trigger a complete write-down of the nominal value of all Credit Suisse additional tier 1 bonds. We believe Credit Suisse is most likely to be an isolated incident, while we have been reducing our portfolios’ exposure to Credit Suisse significantly over the past several months.
Addressing developments at regional banks
The U.S. government's actions to minimize risk across the banking industry following the events of Silicon Valley Bank and Signature Bank have strong potential to prevent further bank runs and subsequent bank failures. But scrutiny of some regional banks will persist.
Citywire Selector: Fed insider-turned-bond boss backs central banks to beat inflationMarch 2023 | 1 min
Head of Fixed Income and Preferred Securities Bill Scapell spoke with Citywire Selector about Cohen & Steers’ preferred securities strategy and his fixed income outlook as central banks battle inflation.
Index definitions / Important disclosures
An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes.
Preferred securities: ICE BofA Fixed Rate Preferred Securities. In sample exhibit:50% ICE BofA Fixed Rate Preferred Securities Index and 50% ICE BofA Capital Securities Index through December 31, 2016; 60% ICE BofA US IG Institutional Capital Securities Index, 30% ICE BofA Core Fixed Rate Preferred Securities Index and 10% Bloomberg Developed Market USD Contingent Capital Index through 12/31/2018; and 60% ICE BofA US IG Institutional Capital Securities Index, 20% ICE BofA Core Fixed Rate Preferred Securities Index and 20% Bloomberg Developed Market USD Contingent Capital Index for periods thereafter. The ICE BofA Capital Securities Index is a subset of the ICE BofA US Corporate Index including all fixed-to-ﬂoating rate, perpetual callable and capital securities. The ICE BofA Fixed Rate Preferred Securities Index tracks the performance of fixed-rate U.S. dollar-denominated preferred securities issued in the U.S. domestic market. Municipal bonds: ICE BofA Municipal Master Index (Credit quality: AA-) tracks the performance of U.S. dollar-denominated investment-grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions, in the U.S. domestic market. Corporate bonds: ICE BofA Corporate Master Index (Credit quality: A-) tracks the performance of U.S. dollar-denominated investment-grade corporate debt publicly issued in the U.S. domestic market. High yield bonds: ICE BofA High Yield Master Index tracks the performance of U.S. dollar-denominated below- investment-grade corporate debt publicly issued in the U.S. domestic market. Emerging market debt: Bloomberg EM Hard Currency Aggregate Index, which includes debt from sovereign, quasi-sovereign, and corporate issuers.
Data quoted represents past performance, which is no guarantee of future results. The views and opinions in the preceding commentary are as of the date of publication and are subject to change without notice. There is no guarantee that investors will experience the type of performance reﬂected in this commentary. There is no guarantee that any historical trend illustrated in this commentary will be repeated in the future, and there is no way to predict precisely when such a trend will begin.
There is no guarantee that a market forecast made in this commentary will be realized. The mention of specific securities is not a recommendation or solicitation for any person to buy, sell or hold any particular security and should not be relied upon as investment advice. This material represents an assessment of the market environment at a specific point in time, should not be relied upon as investment advice, is not intended to predict or depict performance of any investment and does not constitute a recommendation or an offer for a particular security. We consider the information in this material to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of appropriateness for investment. Please consult with your investment, tax or legal professional regarding your individual circumstance before investing.
Risks of investing in preferred securities. Investing in any market exposes investors to risks. In general, the risks of investing in preferred securities are similar to those of investing in bonds, including credit risk and interest-rate risk. As nearly all preferred securities have issuer call options, call risk and reinvestment risk are also important considerations. In addition, investors face equity-like risks, such as deferral or omission of distributions, subordination to bonds and other more senior debt, and higher corporate governance risks with limited voting rights. Risks associated with preferred securities differ from risks inherent with other investments. In particular, in the event of bankruptcy, a company’s preferred securities are senior to common stock but subordinated to all other types of corporate debt. Throughout this commentary we make comparisons of preferred securities to corporate bonds, municipal bonds and Treasury securities. It is important to note that corporate bonds sit higher in the capital structure than preferred securities and therefore, in the event of bankruptcy, will be senior to the preferred securities. Municipal bonds are issued and backed by state and local governments and their agencies, and the interest from municipal securities is often free from both state and local income taxes. Treasury securities are issued by the U.S. government and are generally considered the safest of all bonds since they are backed by the full faith and credit of the U.S. government as to timely payment of principal and interest; additionally, U.S. Treasury interest is generally free from state and local income taxes.
Preferred funds may invest in below-investment-grade securities and unrated securities judged to be below investment grade by the Advisor. Below investment-grade securities or equivalent unrated securities generally involve greater volatility of price and risk of loss of income and principal, and may be more susceptible to real or perceived adverse economic and competitive industry conditions than higher-grade securities.
Contingent capital securities (sometimes referred to as “CoCos”) are debt or preferred securities with loss absorption characteristics built into the terms of the security, for example a mandatory conversion into common stock of the issuer under certain circumstances, such as the issuer’s capital ratio falling below a certain level. Since the common stock of the issuer may not pay a dividend, investors in these instruments could experience a reduced income rate, potentially to zero, and conversion would deepen the subordination of the investor, hence worsening the investor’s standing in a bankruptcy. Some CoCos provide for a reduction in the value or principal amount of the security under such circumstances. In addition, most CoCos are considered to be high yield or “junk” securities and are therefore subject to the risks of investing in below-investment-grade securities.
Duration risk. Duration is a mathematical calculation of the average life of a fixed-income or preferred security that serves as a measure of the security’s price risk to changes in interest rates (or yields). Securities with longer durations tend to be more sensitive to interest rate (or yield) changes than securities with shorter durations. Duration differs from maturity in that it considers potential changes to interest rates, and a security’s coupon payments, yield, price and par value and call features, in addition to the amount of time until the security matures. Various techniques may be used to shorten or lengthen the Fund’s duration. The duration of a security will be expected to change over time with changes in market factors and time to maturity.
No representation or warranty is made as to the efficacy of any particular strategy or the actual returns that may be achieved.
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Cohen & Steers Capital Management, Inc. (Cohen & Steers) is a registered investment advisory firm that provides investment management services to corporate retirement, public and union retirement plans, endowments, foundations and mutual funds. Cohen & Steers U.S. registered open-end funds are distributed by Cohen & Steers Securities, LLC, and are available only to U.S. residents.
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