Preferreds’ income rates compare favorably with other fixed income classes on both a pre- and post-tax basis.
KEY TAKEAWAYS
- Preferreds offer some of the highest yields within investment-grade fixed income.
- Income from preferreds is mostly treated as dividends rather than interest, taxed at a top rate of just 20%.
- The technical backdrop for preferreds may remain favorable, with limited new supply and steady demand.
High, tax-advantaged income
Preferred securities are issued mostly by high-quality issuers, but due to their subordinated position in the capital structure, they often pay higher income rates than similarly rated bonds. Many of these distributions are classified as qualified dividend income (QDI) and taxed at a top rate of 20%, compared to 37% for ordinary interest income (plus a 3.8% Medicare surcharge for both). This combination of high coupons and tax-advantaged treatment creates the potential for attractive after-tax income relative to other fixed income categories. It also makes preferreds a compelling complement to municipal bonds.
Using current index yields as proxies, a hypothetical $1 million investment in preferreds would potentially generate $60,000 per year in pre-tax income. Assuming that 65% of the income generated is QDI eligible, that translates to $42,150 per year after taxes for investors in the top tax bracket—saving $6,630 in taxes, compared to the same income fully treated as interest.
Preferreds can offer tax-advantaged income for U.S. investors(a)
At September 30, 2024. Source: Cohen & Steers, Bloomberg, ICE BofA.
Data represents past performance, which is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes. Debt securities including preferred securities, corporate bonds, municipal bonds and high yield bonds generally present various risks, including interest rate risk, credit risk, call risk, prepayment and extension risk, convertible securities risk, and liquidity risk. Index comparisons have limitations as volatility and other characteristics may differ from a particular investment. The above is not intended to serve as tax advice. Investors should consult with their respective tax advisors prior to making an investment. (a) Yields shown on a yield-to-maturity basis. (b) Assumes taxation at the highest marginal U.S. Federal income tax rates of 37% for taxable interest income and 20% for QDI, with an additional 3.8% Medicare surcharge on all tax rates. After tax calculations assumes preferred securities income is taxed at the respective qualified dividend rate and marginal tax rate on a 65/35 blended basis. All other securities reflect full taxation at the respective marginal rates based on income. Note: State and local taxes are not included in these calculations. See endnotes for index associations and definitions and additional disclosures, including after-tax assumptions.
Notably, the technical backdrop for preferreds may remain favorable amid limited net new supply in an environment of strong demand for quality income. Assuming the Federal Reserve’s rate-cutting cycle continues to unfold, lower yields on money market funds and short-term bonds may lessen the appeal of “safe havens” and result in investor demand for higher-income solutions such as preferreds (and low-duration preferreds), particularly on an after-tax basis.
FURTHER READING
Five reasons to consider preferred securities if you own municipal bonds
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.
3 Reasons to own preferred securities today
We believe an exceptional buying opportunity for preferred securities may exist today.
Preferred securities call alert—$19.3 billion reinvestment opportunity
Investors are facing new challenges as many of their single-issued preferred securities may be subject to call—including some that are trading above par and could lose value. Now may be the time to look beyond single issues to the added value of an actively managed portfolio.
Index definitions / important disclosures
This material is for informational purposes, and reflects prevailing conditions and our judgment as of this date, which are subject to change. There is no guarantee that any market forecast set forth in this presentation will be realized.
This material represents an assessment of the market environment at a specific point in time and should not be relied upon as investment advice, does not constitute a recommendation to buy or sell a security or other investment and is not intended to predict or depict performance of any investment. This material is not being provided in a fiduciary capacity and is not intended to recommend any investment policy or investment strategy or take into account the specific objectives or circumstances of any investor. We consider the information in this presentation 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.
Cohen & Steers does not provide investment, tax or legal advice. Please consult with your investment, tax or legal professional regarding your individual circumstances prior to investing.
An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes. 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. Corporate bonds are taxed at 100% ordinary income. High yield bonds: ICE BofA High Yield Master Index (Credit quality: B+) tracks the performance of U.S. dollar-denominated below-investment-grade corporate debt publicly issued in the U.S. domestic market. Low duration preferred securities: ICE BofA 8% Constrained Developed Markets Low Duration Capital Securities Custom Index (Credit quality: BBB-) tracks the performance of select U.S. dollar-denominated fixed and floating-rate preferred, corporate and contingent capital securities, with a remaining term to final maturity of one year or more, but less than five years. Preferred Securities after-tax calculations assume preferred securities income is taxed at the respective qualified dividend rate and marginal tax rate on a 65/35 blended basis. 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. Municipal Bonds’ income is exempt from federal taxation. Preferred securities: ICE BofA Fixed Rate Preferred Securities Index (Credit quality: BBB) tracks the performance of fixed-rate U.S. dollar-denominated preferred securities issued in the U.S. domestic market. Preferred Securities after-tax calculations assume preferred securities income is taxed at the respective qualified dividend rate and marginal tax rate on a 65/35 blended basis. 10-year U.S. Treasury: The 10-Year Treasury note is a debt obligation issued by the United States government that matures in 10 years. Treasury bonds are fully taxable at the federal level at the taxable interest income rate of 37%.
Risks of investing in preferred securities. An investment in a preferred securities is subject to investment risk, including the possible loss of the entire principal amount that you invest. The value of these securities, like other investments, may move up or down, sometimes rapidly and unpredictably. 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.
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. The duration of a security will be expected to change over time with changes in market factors and time to maturity.
Cohen & Steers Capital Management, Inc. (Cohen & Steers) is a U.S. registered investment advisory firm that provides investment management services to corporate retirement, public and union retirement plans, endowments, foundations and mutual funds. Cohen & Steers UK Limited is authorised and regulated by the Financial Conduct Authority of the United Kingdom (FRN458459). Cohen & Steers Ireland Limited is regulated by the Central Bank of Ireland (No.C188319). Cohen & Steers Asia Limited is authorised and regulated by the Securities and Futures Commission of Hong Kong (ALZ367). Cohen & Steers Japan Limited is a registered financial instruments operator (investment advisory and agency business and discretionary investment management business with the Financial Services Agency of Japan and the Kanto Local Finance Bureau No. 3157) and is a member of the Japan Investment Advisers Association. Cohen & Steers SingaporePrivate Limited is a private company limited by shares in the Republic of Singapore.