Income investing redefined: The case for preferred securities

Income investing redefined: The case for preferred securities

Income investing redefined: The case for preferred securities

Elaine Zaharis-Nikas, CFA

Head of Fixed Income and Preferred Securities

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Jerry Dorost, CFA

Portfolio Manager, Fixed Income and Preferred Securities

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Robert Kastoff, CFA

Portfolio Manager, Fixed Income and Preferred Securities

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30 minute read

February 2025

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High yield does not have to mean high risk—preferred securities offer investors a compelling middle ground, providing attractive income, total returns and portfolio diversification from high-quality issuers.

KEY TAKEAWAYS

  • A large and unique asset class with interest rate resilience
    Preferreds are an appealing investment primarily issued in less-rate-sensitive structures, by noncyclical companies with stable business models in regulated industries that are under-represented in other fixed income categories.
  • High income and other valuable investment characteristics
    Preferreds have historically delivered high (often tax-advantaged) income, strong total returns and diversifying correlations with other fixed income asset classes.
  • Enhanced risk/return potential for fixed income portfolios
    An allocation to preferreds in a broad fixed income portfolio may increase income and total return while keeping the risk profile relatively stable. Active investment managers may add value by accessing opportunities globally.

A large and unique asset class

Preferreds hold a distinctive position in capital markets, yet they are frequently an underappreciated investment option. They are a form of equity for issuers, helping companies reach capitalization goals for regulatory and rating agency purposes. However, from an investor standpoint, preferreds act like bonds, not stocks—they simply offer a fixed or floating rate of income. Issued at par like debt instruments, their market prices fluctuate with changes in interest rates and credit fundamentals; hence, preferreds can trade at premiums or discounts to par value.

Preferred securities lie between common stock and senior debt in a company’s capital structure (Exhibit 1). Preferred shareholders rank below senior debtholders in the event of liquidation—presenting subordination risk that partly explains preferreds’ higher income and wider credit spreads. Additionally, preferred coupon payments are discretionary and subject to deferral or outright omission, but such actions are extremely rare in practice, typically only occurring in cases of great corporate strain.

Preferreds come in two varieties: perpetual and hybrid. Perpetual preferreds are special forms of high-dividend-paying equities that have existed for more than a century. Hybrid preferreds are a more modern invention, created in the 1990s. These instruments are forms of long-term, junior subordinated deferrable debt. As forms of debt, they pay interest income.

EXHIBIT 1
While typically high quality, preferreds are subordinated to conventional debt instruments

Credit class rankings

While typically high quality, preferreds are subordinated to conventional debt instruments

A broad and liquid universe

The $1.3 trillion global preferred securities universe is large and liquid, offering ample investment opportunities. There are two distinct trading markets for preferreds (Exhibit 2). Exchange-traded preferred securities are designed for retail investors, typically with $25 par shares that pay quarterly dividends and offer the trading ease of an exchange (predominantly the New York Stock Exchange). While the U.S. exchange-traded market is fairly large (around $180 billion), issuers are increasingly turning to the far larger, institutionally traded over-the-counter (OTC) preferreds market, which is valued at more than $1 trillion globally across currencies. OTC preferreds trade just like bonds, in $1,000 par increments and generally in $1 million blocks. Many are in 144A and Regulation S (offshore) format, requiring institutional status and/or a local presence for purchase(1). Like bonds, OTC preferred securities typically pay dividends semiannually.

One type of OTC preferreds, which makes up approximately 25% of the total market, is contingent capital (“CoCo”) securities. CoCos are widely used by financial issuers outside of the U.S. to meet capital requirements. These securities will write down or convert to common stock in the event that the issuer’s capital level falls below a particular threshold or if the bank reaches a point of nonviability. Given this risk, CoCos can offer excess compensation relative to other fixed income segments.

Another notable feature of the OTC preferreds market is that it is dominated by lower-duration, fixed-to-fixed-rate or fixed-to-floating-rate securities. In contrast, the exchange-listed market is dominated by issues that pay fixed rates of income. We will discuss the differences between these structures in greater detail, but for now, it is worth noting that the OTC market tends to offer a lower level of interest rate risk. The OTC market may also offer superior levels of call protection for investors (longer periods for which the issuer cannot redeem the security); many new-issue OTC securities have up to 10 years of call protection, compared with the five-year norm in the exchange- listed market.

EXHIBIT 2
A large, global institutional market

Total preferreds market size: $1.3 trillion

A large, global institutional market

A complement within fixed income

It is no coincidence that the issuers of preferred securities are mainly large, highly regulated institutions and/or companies with high, stable and transparent cash flows—such as banks, insurance companies, utilities, pipeline companies and real estate investment trusts (REITs). Given the discretionary nature of dividend payments, investors generally demand high-quality, tested business models, which may provide an adequate comfort level that the expected income will be delivered.

Because of these characteristics, preferreds can bring attractive diversification benefits when included in portfolios with corporate bond and high-yield allocations, as the asset classes have different sector exposures (Exhibit 3). The main sectors that issue preferreds represent less than 40% of sector exposure in corporate bonds and even less in high-yield bonds. High yield, for instance, has a significant energy sector component, whereas the preferreds market has little exposure to those typically cyclical and leveraged companies. In contrast to the corporate bond market, financial companies account for more than half of the preferreds universe (and have less cyclical features).

EXHIBIT 3
Low sector overlap with other fixed income classes

Sector weight representation

Low sector overlap with other fixed income classes

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Regulatory reforms have led to solid financial industry fundamentals

Some investors remain leery of banks given the well-publicized 2023 failures of a few U.S. regional banks and Credit Suisse’s forced sale to UBS. However, those failures were idiosyncratic, not symptomatic of issues underlying the banking sector. The credit fundamentals of financial companies have improved dramatically since the global financial crisis. Under rules recommended by the Basel Committee on Banking Supervision (i.e., Basel III) the regulatory requirements governing banks globally have become far more stringent.

The asset quality, funding and capital of the majority of large banks in the U.S. and other developed markets today are strong. U.S. bank capital reached record levels in 2024, with solid earnings supporting capital building and retention. On average, bank capital levels today are around twice as strong as in 2008. We believe strong capital and reserves provide a cushion against future loan losses and may provide a credit tailwind for the industry.

Preferred securities offer the potential for attractive total returns that can be resilient even in a rising interest rate environment.

Security structures that may help mitigate interest rate risk

Preferred securities offer the potential for attractive total returns that can be resilient even in a rising interest rate environment. While many issues are long term or perpetual, lower-duration fixed-to-reset structures dominate the OTC market. (They are also available on a more limited basis in the exchange-traded market.) Such structures have proven to help cushion the impact of a rising interest rate environment.

We can measure the potential interest rate risk by examining a security’s duration—a mathematical calculation of the average life of a fixed income or preferred security that measures the security’s price risk with respect to changes in interest rates (or yields). Generally, the higher the duration, the greater the price change response will be to a given rise or fall in the demanded yield of the security.

There are different structures in the preferreds market, which lead to very different duration (interest rate risk) profiles (Exhibit 4).

EXHIBIT4
A preferred security’s duration is largely determined by its structure

Hypothetical examples

A preferred security’s duration is largely determined by its structure

Higher income levels, both before and after taxes

Investment-grade preferred securities typically offer some of the highest income rates in high-grade fixed income markets. Moreover, the net after- tax income from preferreds may be higher than that available from other taxable fixed income types, even tax-exempt bonds (Exhibit 5).

Individual investors: Many preferred securities pay qualified dividend income (QDI), which for U.S. investors is taxed at just 20%, plus the 3.8% Medicare surcharge, for top earners (compared with 37% + 3.8% for interest income). The combination of high income rates and lower taxes has historically given preferreds an after-tax yield advantage over other fixed income categories. Exhibit 5 illustrates pre- and post-tax income rates, assuming QDI taxes for investment-grade preferreds, compared with a few other fixed income assets. For top earners, preferreds offer after-tax yields on par with high-yield bonds, which are typically five or more notches lower in credit quality (BBB vs. B+) and entail significantly more credit risk.

Corporate investors: U.S. institutional investors structured as
C-corporations can take advantage of the “dividends received deduction” (DRD) tax treatment, reducing the tax rate on income from qualifying preferreds. For a corporate investor with a 21% tax rate, the effective tax on preferred income may fall to just 10.5%. This means a DRD-eligible preferred paying 6.0% would have an after-tax yield of 5.4%, compared with just 4.7% for a non-DRD security with the same pre-tax yield.

EXHIBIT 5
Preferreds offer high income for high-quality issuers

Pre-and post-tax fixed income yields (%)

Preferreds offer high income for high-quality issuers

Returns driven mainly by high income and low default rates

Across full market cycles, preferred securities tend to be among the top- performing fixed income categories. The return experience in the 10 years through December 2024 shows how preferreds compare favorably to investment-grade and high-yield bonds, particularly on an after-tax basis (Exhibit 6).

The substantial income advantage of preferreds was the most significant driver of their outperformance, relative to other investment-grade securities in the last 10 years. The price performance of preferreds also reflects their quality, with little influence from defaults or impairments, which often act as a drag on the performance of high-yield bonds. Preferreds are rated on the same scale as debt instruments. Depending on the issuer and structure, preferred stocks may be rated up to six notches lower than the senior debt of the same issuer. Since companies can suspend preferred dividend payments without stopping bond payments, the agencies perceive a higher default probability for a preferred than for a bond from the same issuer.

However, a Moody’s study showed that the impairment rates (defaults or missed payments) for preferred securities they rated were “…similar to average cumulative default rates of global corporates overall and by like rating category.”(2) Similarly, in a study encompassing 40 years of data, S&P Global’s analysis of global financial services companies (the main issuers of preferreds) showed that BBB–/BB+ rated securities (typical ratings for most preferreds) historically had default rates under 1%(3). In contrast, defaults on high-yield bonds have averaged 3.6% annually (and at times have been much higher). As a result, preferreds often remain more appealing than high-yield bonds, as the latter’s cyclical defaults typically erase their income advantage.

EXHIBIT 6
Preferreds’ solid relative returns are supported by their high income rates

10-year annualized total return (%)

Preferreds’ solid relative returns are supported by their high income rates

Low correlations with other asset classes

Preferred securities have shown diversifying correlations with both equities and other fixed income asset classes. This is partly because banks and insurance companies, the largest issuers of preferred securities, are typically not well represented in other fixed income strategies (such as high-yield bonds). Exhibit 7 shows the 10-year correlation of the selected investment strategies with one another. Low correlations with other asset classes provide strong support for preferred securities as a portfolio diversifier.

EXHIBIT 7
Preferreds can offer attractive correlations with other income sources

10-year correlations of monthly returns

Preferreds can offer attractive correlations with other income sources

For investors looking beyond traditional fixed income, preferred securities may offer an attractive solution.

Enhanced risk/return potential with preferreds

Since the correlations of preferreds with other fixed income and equity assets have historically been somewhat modest, the securities may have the potential to improve the risk-adjusted returns of diversified portfolios. To illustrate this potential, Exhibit 8 shows, how over the past 10 years, a 20% allocation to preferred securities in a broad fixed income portfolio has increased income and total return while keeping the risk profiles relatively stable.

Investors interested in accessing preferreds should note that these securities typically account for only very small portions of large bond funds, including bond-focused ETFs.

Investors may choose to source a dedicated preferreds allocation from many possible existing allocations; for example, the chart below shows adding from corporates, mortgage-backed bonds and emerging market debt.

EXHIBIT 8
Preferreds securities may improve risk-adjusted returns

Sample fixed income asset allocation portfolios over 10 years

Preferreds securities may improve risk-adjusted returns

Market inefficiencies can create opportunities for active managers

In our view, preferred securities offer a number of distinctive features and benefits, including high income (potentially with tax advantages), strong total returns and diversifying correlations from a large, global universe of high-quality issuers with stable business models that are less affected by economic fluctuations.

Preferred securities can complement, diversify and improve a fixed income investment allocation. Yet these instruments are complicated, and the market is inefficient.

Active managers have the means to make portfolio adjustments to address changing market conditions, using tools to manage duration, credit risk and interest rate risk to potentially reduce volatility and achieve better risk- adjusted returns. In our experience of managing preferreds, we have found that greater diversification (whether by issuer, sector or region) offers more relative value opportunities and a superior ability to manage risks.

In today’s environment, we believe a combination of global reach and active management—based on dedicated research into preferred securities markets and issuers—is the best formula for pursuing desired results.

A dedicated preferreds manager can help investors navigate complex markets and achieve desired total return and yield objectives.

ABOUT THE AUTHORS
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Elaine Zaharis-Nikas, CFAis Head of Fixed Income and Preferred Securities and a senior portfolio manager for the firm’s preferred securities portfolios.

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Jerry Dorost, CFA, Senior Vice President, is a portfolio manager for fixed income and preferred securities portfolios and has analyst coverage responsibilities for U.S. banks.

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Robert Kastoff, CFA, Vice President, is a portfolio manager for fixed income and preferred securities portfolios and has analyst coverage responsibilities for real estate and telecommunication industries.

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