Preferred Securities: High Income, but Near-Record Prices
For investors considering preferred securities today, there is good news and bad news.
The good news is that preferred securities can offer investors higher income payments than many other fixed income investments, and large banks are generally in good shape to make those payments to preferred security holders.
The bad news is that prices of preferred securities have rarely been higher than they are today. We see little room for price appreciation at this point, and a greater risk that prices will fall, albeit modestly, from current levels.
Investors may still consider preferreds today, but they should always be treated as long-term investments. Preferreds have long maturity dates—or no maturity dates at all—so investors should be willing to hold them for long periods of time, earning the income while riding the ups and downs of their price volatility.
Positives for preferred securities
1. Financial institutions passed the Federal Reserve’s stress tests. Each year, the Federal Reserve conducts stress tests on the largest financial institutions to test how they would perform during financially stressful conditions. The tests cover hypothetical scenarios, including shocks to economic growth and the labor market, and the results showed that the largest financial institutions could likely handle those shocks. Even in the Fed’s “severely adverse” scenario—assuming the unemployment rate rises above 10%, gross domestic product falls for seven straight quarters, and stock prices drop 55%—the largest banks would all have capital levels above the minimum risk-based requirements as prescribed by the Fed.1 Preferred securities issued by financial institutions make up more than half of the preferred security market.
Large financial institutions would still be well capitalized in a severely adverse scenario
Source: Federal Reserve, “Dodd-Frank Act Stress Test 2021: Supervisory Stress Test Results,” June 2021. The Common Equity Tier 1 Ratio is calculated as common equity tier 1 capital divided by risk-weighted assets and is meant to show how well a financial institution can withstand financial stress.
Importantly for preferred stockholders, the temporary capital distribution restrictions that the Fed imposed in 2020 will be lifted as a result of these stress tests. After the results of the June 2020 stress tests, the Fed capped the amount that banks could distribute as dividends or could be used for share buybacks. With those restrictions lifted, some large banks have already announced increases to their common stock dividends, with one large U.S. bank doubling its annual dividend. Since common stock dividends can only be paid after preferred stock dividends, banks are highly incentivized to make timely preferred stock payments.
2. Preferred securities have high yields and coupon rates. Preferreds pay some of the highest coupon payments of all fixed income investments—an important characteristic for those investors looking for higher income payments, such as people who are in or nearing retirement.
Preferred securities have relatively high average coupon rates
Source: Bloomberg, as of 6/30/2021. Chart shows average coupon rates of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index (High-Yield Corporates), ICE BofA Fixed Rate Preferred Securities Index (Preferred Securities), Bloomberg Barclays U.S. Corporate Bond Index (Investment Grade Corporates), and Bloomberg Barclays U.S. Aggregate Bond Index (U.S. Aggregate Bond Index).
Preferred security yields aren’t straightforward, however. Most preferreds are callable, meaning they can be redeemed by the issuer, usually at par value, after a certain amount of time has passed. If a preferred security’s price is above its par value and it can be called soon, it may have a negative yield-to-call (YTC).2
The average yield-to-maturity (YTM) of the ICE BofA Fixed Rate Preferred Securities Index is 4.1%, but the yield-to-worst is just 1.8%. The yield-to-worst is the lower of the YTM or the YTC.3 Investors who invest in individual preferred securities should always be cognizant of the price paid (especially if it is above par) and if it has an upcoming call date in case the yield-to-call is negative. For those who invest using a mutual fund, exchange-traded fund, or a separately managed account, the extra diversification may help mitigate some of the negative yield-to-call risk.
Negatives for preferred securities
1. Prices are high. There’s very little room for price appreciation going forward. Coupon payments should be the driver of total returns over the next six to 12 months, not price gains. The average price of the ICE BofA Fixed Rate Preferred Securities Index is approaching $108, not far from its all-time high of $108.7 reached in 2013.
Preferred securities prices have rarely been higher
Source: Bloomberg, using weekly data as of 6/30/2021. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Higher long-term Treasury yields could pose a risk to preferred securities’ prices if they lead to higher borrowing costs for banks. If Treasury yields rise as we expect, investors may demand higher yields from preferred securities to compensate for the greater risks they offer compared to U.S. Treasuries.
2. Prices tend to be volatile. The high interest rate sensitivity coupled with high credit risk—despite the “preferred” descriptor, preferreds rank below traditional bonds—generally results in price volatility. Preferred prices tend to have wide price fluctuations in most years. From 2010 through 2020, the average gap between the high price and low price each year was $11, ranging from a narrow range of just $3.8 in 2015 to a wide range of almost $27 in 2020. The average price of the preferred index is rebased to $100, despite many of its underlying holdings having par values of $25. As a result, the price fluctuations of preferred securities with par values of $25 wouldn’t likely be as large in dollar terms as what’s illustrated in the chart below, but would be similar in percentage terms.
Preferred prices tend to trade in a wide range
Source: Bloomberg. The columns represent the high and low average par-weighted price for the ICE BofA Fixed Rate Preferred Securities Index. The year 2021 is as of 6/30/2021. Past performance is no guarantee of future results.
Price fluctuations occur even during good times. With prices so high today, and given how tight the trading range has been in the first half of this year, it wouldn’t be too surprising to see modest price declines as the year progresses.
Invest for the long run
Given those potential price fluctuations, preferreds should always be considered long-term investments. After all, with no maturity dates, or very long maturity dates, they are not appropriate as short-term investments. If you’ll need the funds at some point in the near future, you don’t know in advance what the value of the preferred security investment will be over the short run.
If you have a long-term investing horizon, however, preferreds can make sense even with the high prices today. Investors can earn some of the highest income payments available, but you’ll need to be able to withstand potentially volatile prices.
Over longer investing periods, preferred security total returns have rarely been negative. As the chart below illustrates, over two-year holding periods dating back to 1992, total returns were positive in all instances except during the 2008-2009 financial crisis. Given how well-capitalized banks are today, we believe the risk of a repeat of that experience is low.
Preferred securities generally had positive total returns over 2-year investment horizons
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 January 1992 through June 2021. 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 guarantee of future results.
What to do now
Consider preferred securities for the higher income payments they provide, but keep your total-return expectations in check. There’s very little room for prices to rise, while prices could fall modestly if long-term Treasury yields do begin to climb in the second half of the year.
For those considering preferred securities, make sure you have a long-term investing time horizon and risk tolerance to ride out the ups and downs—their prices tend to be volatile. We believe preferred securities should serve as a complement to a well-diversified, high-quality fixed income portfolio, not a substitute.
1 “Dodd-Frank Act Stress Test 2021: Supervisory Stress Test Results,” Board of Governors of the Federal Reserve System, June 2021.
2 Yield to call (YTC) refers to the return a bondholder receives if the bond is redeemed at the next call date, which occurs sometime before it reaches maturity.
3 Yield to worst (YTW) is the lower of the yield-to-maturity (YTM) or the yield-to-call. It’s the lowest possible annualized return an investor can from a given investment, aside from default.
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