Preferred Securities: Still Attractive Despite Modestly Higher Prices

by: Charles Schwab
Summary

Preferred securities still appear attractive for long-term investors.

Despite the sharp rise in prices over the past few months, preferred securities still offer relatively attractive yields.

Like a common stock, a preferred security can represent an ownership stake in a company, entitling its holder to a share of the profits (in the form of coupon payments).

By Collin Martin

Preferred securities still appear attractive for long-term investors.

Despite the sharp rise in prices over the past few months, preferred securities still offer relatively attractive yields. Although the entry point isn't as attractive as it was just a few months ago, preferred securities may still make sense for those willing to take higher risk in exchange for potentially higher income payments.

Here we'll take a closer look at how preferred securities work and how they've fared over long investing horizons. We'll also discuss a few considerations to keep in mind when adding them to the income-generating part of a portfolio.

How do preferreds work?

Preferred securities are hybrid investments that share certain characteristics of both stocks and bonds. Like a common stock, a preferred security can represent an ownership stake in a company, entitling its holder to a share of the profits (in the form of coupon payments).

"Preferred" refers to the order in which investors can expect to get paid. Bondholders typically get first dibs on any coupon payments, followed by holders of preferred securities. Owners of common stock get paid out of what's left.

Then there are the bond-like features. Preferred securities make coupon payments at either a predetermined fixed or variable coupon rate-though there's no guarantee coupons will always be paid. Most have maturities, which tend to be long, though many don't (these are perpetual preferred securities). However, preferred securities also tend to be "callable," meaning they can be retired prior to maturity at a specified price after a specified date. They also have a par value-or face value-which is generally the amount promised to an investor when (or if) the securities mature or are repaid.

Like bonds, preferreds also carry credit ratings from agencies like Moody's Investors Service or Standard and Poor's. However, the rating for an issuer's preferred security is often lower than the rating on the issuer's bonds.

A look at yields

The hybrid characteristics and distinct risks are the main reason preferred securities tend to offer relatively high yields. For example, the ICE BofAML Fixed Rate Preferred Securities Index, a broad gauge of the investment-grade preferred securities market, has a 5.8% average coupon rate. That's higher than most investment-grade bonds, as you can see in the chart below.

How do preferreds stack up against other fixed income investments?

On 3/31/2019, average coupon rates were: Bloomberg Barclays U.S. Corporate High-Yield Bond Index, 6.4%; ICE BofAML Fixed Rate Preferred Securities Index, 5.8%; Bloomberg Barclays U.S. Corporate Bond Index, 4%; Bloomberg Barclays U.S. MBS Index, 3.6%; Bloomberg Barclays U.S. Treasury Bond Index, 2.4%.

Source: Bloomberg and Barclays, as of 3/31/2019. Indexes representing the investment types are Bloomberg Barclays U.S. Corporate High-Yield Bond Index (high-yield corporates), ICE BofAML Fixed Rate Preferred Securities Index (preferred securities), Bloomberg Barclays U.S. Corporate Bond Index (investment-grade corporates), Bloomberg Barclays U.S. MBS Index (agency mortgage-backed securities) and the Bloomberg Barclays U.S. Treasury Index (Treasuries). Past performance is no guarantee of future results.

Are they still attractive today?

Yes, even though preferred securities' prices have risen sharply over the past few months as long-term Treasury yields have moved lower (remember that bond prices and bond yields move in opposite directions). But despite the rise, they're still below their five-year average. The strong start to the year has propelled the ICE BofAML Fixed Rate Preferred Securities Index to a total return of 8.7% in the first quarter alone.

Despite the rise, preferred securities' prices are still below the 5-year average

The ICE BofAML Fixed Rate Preferred Securities Index was at $102 on 3/31/2019, below its five-year average of $102.9.

Source: Bloomberg, using monthly data as of 3/31/2019. Past performance is no guarantee of future results.

While the price increase makes it a bit less attractive to invest in preferred securities today compared to just a few months ago, average forward returns still look favorable, based on past performance.

The chart below breaks down the average 12-month total return of the ICE BofAML Fixed Rate Preferred Securities Index, broken down by various average starting price cohorts. While returns have been the most favorable when prices are below $100, the current price of $102 still presents a relatively attractive entry point.

Average total returns, while historically strongest at prices below $100, are still relatively favorable at starting prices between $100 and $105

Historically, when ICE BofAML Fixed Rate Preferred Securities Index starting prices have averaged between $100 and $105, forward 12-month total return has averaged 5%.

Source: Schwab Center for Financial Research and Bloomberg. Forward 12-month total returns of the ICE BofAML Fixed Rate Preferred Securities Index using monthly data from 4/30/1989 through 3/31/2019. Past performance is no guarantee of future results.

What are the risks?

There are a few potential risks to keep in mind. For example, preferred securities tend to have a relatively greater share of:

  • Interest rate risk, or the risk that an investment's value will fall if interest rates rise. That's because the prices and yields of fixed income investments generally move in opposite directions. Because preferred securities have very long maturities, or no maturities at all, they are very sensitive to changes in long-term Treasury yields.
  • Credit risk, or the risk that an issuer can't make timely coupon or principal payments. Since preferred securities generally rank below an issuer's bonds, and because their coupon payments are generally discretionary, they have elevated credit risk.

Preferred securities should be considered long-term investments

Because preferred securities have very long maturities, or in many cases no maturity dates at all, they should always be considered long-term investments.

Looking at rolling 24-month total returns, the only times the index posted negative returns were in the years leading up to, and then during, the recent financial crisis, as many financial institutions suspended their preferred coupon payments, sending their prices tumbling lower. And while the most recent reading in the chart below may appear low, that has more to do with the scale of the chart than the strength of the return. In the 24-month period ending March 2019, the cumulative total return of the index was 9.3%, besting both the Bloomberg Barclays U.S. Aggregate Bond Index total return of 5.7% and the Bloomberg Barclays U.S. Corporate Bond Index total return of 7.8%.

Over long investing horizons, preferred securities have generally delivered positive total returns

With the exception of the 2008-2009 financial crisis, the ICE BofAML Fixed Rate Preferred Securities Index delivered positive total returns from March 1993 through March 2019.

Source: Schwab Center for Financial Research with data from Bloomberg. Rolling 24-month total returns of the ICE BofAML Fixed Rate Preferred Securities Index from March 1993 through March 2019. Total returns assume reinvestment of income payments and capital gains. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.

What to think about before investing

Preferred securities can help boost the income of a well-diversified portfolio, but they should be considered a complement to your core fixed income holdings, not a substitute. But before investing, consider the following:

  • Investing in preferred securities can be complicated. There are many different types of preferred structures, and different securities can have very different characteristics. For example, repayment guarantees can vary. Some offer to make up for any missed dividends, while others don't. Some offer floating coupon rates that adjust with interest rates. With so many nuances, an active manager may make more sense than a passive, index-tracking investment. An active manager can evaluate each issue individually and make an informed decision about what to own and not to own.
  • If investing in individual preferreds and the price is above its par value, be aware of any upcoming call dates. If a preferred security is purchased above its par value and is quickly redeemed by the issuer, the total return may be negative.
  • Make sure you have a long investing horizon when considering preferred securities, given their long maturities.
  • Finally, for those worried about interest rate risk, we think we've likely seen the peak in long-term interest rates. With the Federal Reserve likely on hold for now, and a possibility that its next move will be a rate cut rather than a rate hike, we think it makes sense to lock in the potentially higher yields that longer-term investments offer.

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.