Five reasons to consider preferred securities if you own municipal bonds

Five reasons to consider preferred securities if you own municipal bonds

11 minute read

February 2023

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With many investors feeling the sting of taxes, municipal bonds aren’t the only option for tax-advantaged income. Preferred securities currently offer among the highest after-tax yields in fixed income, regardless of tax bracket.

1. High coupons from blue chip issuers.

Preferred securities are issued mostly by high-quality companies in the banking, insurance, real estate and utility sectors, many of them household names such as Bank of America, Prudential, AT&T and JPMorgan Chase.(1) However, because preferreds sit lower in the capital structure than senior and subordinated debt, they tend to pay higher income rates than similarly rated bonds.

EXHIBIT 1
Preferreds offer high, tax-advantaged income
Preferreds offer high, tax-advantaged income_Intermediate duration
Preferreds offer high, tax-advantaged income_Low duration

2. Tax-advantaged income.

Typically, distributions from most preferreds are treated as qualified dividend income (QDI), taxed at a top rate of 20%, versus 37% for interest income (plus a 3.8% Medicare surcharge). If we conservatively assume that 65% of preferreds are QDI eligible, the effective top tax rate would be 29.8%—an 11% tax savings.

3. Higher current income potential than munis, before and after taxes.

Using current index yields, a $1 million investment in preferred securities would potentially generate $73K per year in pre-tax income (see Exhibit 1). Assuming 65% QDI, that would translate to $51K per year after taxes for investors in the top tax bracket—providing $8K more in after-tax income than if it were fully treated as interest.(1) This compares favorably to municipal bonds, which potentially offer only $40K per year in tax-free income. Preferreds’ yield advantage may be narrower versus municipal bonds that are exempt from state and local income taxes for investors who purchase the bonds issued by their state or municipality of residence.

Investors emphasizing capital preservation over appreciation may want to consult with their investment professional about low-duration preferred securities, which also offer attractive after-tax yields.

4. A track record of comparable (and often lower) risk.

While municipal bonds are often perceived as being lower-risk securities than preferreds, preferreds have historically compared favorably on key risk factors. Both have a history of low default rates, according to Moody’s data going back decades.(2) We believe preferreds have the potential to maintain low default rates, viewing them as well positioned to withstand periods of slowing or negative economic growth. Regulators annually subject financial companies—the leading issuer of preferreds—to rigorous economic “stress tests” aimed at ensuring adequate capital reserves. The preferred market is also well represented by high- cash-flow, less cyclical companies that investors trust to make regular payments.

High quality issuers and securities dominate both markets
High quality issuers and securities dominate both markets

5. Better together.

Over the past 10 years, a 50/50 mix of municipal bonds and preferred securities would have delivered a higher return than municipals alone. The mix also appears attractive from an after-tax yield perspective, generating 60 basis points of extra yield over standalone municipal bonds (Exhibit 2).

EXHIBIT 2
Adding preferreds to a muni portfolio may improve risk-adjusted returns

10-year statistics

Adding preferreds to a muni portfolio may improve risk-adjusted returns
If you already own municipal bonds, you may want to talk with your financial professional about shifting some of your allocation to preferred securities. This can broaden your portfolio’s diversification—spreading risk across a wider range of issuers— while potentially enhancing take- home income.
Cohen & Steers’ actively managed preferred securities open-end mutual funds
Cohen & Steers’ actively managed preferred securities open-end mutual funds
Adding preferred securities to a portfolio of municipal bonds may help investors achieve better risk-adjusted performance while maintaining a focus on high-quality issuers.

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Upcoming call dates/dividend resets provide preferred securities with a potential catalyst in today's uncertain market. Primarily issued by investment-grade-rated companies, preferred yields are currently in the 7–9% range. Most preferreds come with dividend-resetting structures, potentially leading to income growth for investors in the face of sustained interest rates. Additionally, many securities are selling at 10–20% discounts to par value. Given their historical trend of trading near par, these deep discounts present significant potential for capital appreciation for patient investors.

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