Preferred Securities: Higher Yields, Different Risks
Preferred securities may be appealing to aggressive investors looking for higher yields in a low-interest-rate environment.
Preferred securities have very distinct characteristics, with both stock-like and bond-like qualities.
Before you invest, it's important to know the details and terms of particular securities.
Preferred securities are a type of investment that generally offers higher yields than traditional fixed income securities such as U.S. Treasuries or investment-grade corporate bonds. However, the higher yields come with different risks.
Preferred securities are sometimes considered by investors seeking higher income. They were also one of the hardest-hit investments during the 2008 credit crisis. What should you be aware of now to decide whether preferred securities might be the right investment for you for a more-aggressive part of your income portfolio?
What are preferred securities?
Preferred securities are "hybrid" investments, sharing characteristics of both stocks and bonds. (Technically, preferred securities are a subset of hybrids. However, in recent years, the term "preferred security" has been used as a blanket term to encompass anything from $25 par¹ senior debt down to traditional preferred stock). Like stocks, they're generally paid after a company's bonds. Like bonds, however, they usually make regular fixed payments and have a par value that is returned to the investor if or when the securities mature or are redeemed by the issuer, barring default. The price of a preferred security can still fluctuate in the secondary market, however. Preferred securities have very long maturities—usually 30 years or more—or have no maturity date at all, meaning they are perpetual securities.
For this discussion, we'll consider preferred securities with a par value of $25 and that, in an issuer's capital structure, rank anywhere from just above common stock to as high as senior unsecured debt.
Preferred securities generally provide higher yields than many alternatives—though there are good reasons investors demand the higher yields:
- Less growth potential. Preferred securities have fixed par values, like bonds, and tend not to increase in value as common stock may if a company grows. While some preferreds represent an ownership interest, the interest is only in fixed payments, not a growing earnings stream. So the price generally doesn't appreciate much above the fixed par value.
- Weaker guarantees. Preferred securities don't provide the same guarantees of interest payments and payment at maturity as bonds. In bankruptcy, for example, corporate bond owners are paid before holders of preferred securities. In addition, for most types of preferred securities, management can defer payments at its discretion if the company runs into a tough period. This can't be done with traditional bonds, short of bankruptcy. Deferrals of payments don't happen often—partly because a deferral would likely limit the appeal to investors, but also because a company isn't permitted to pay dividends on common stock while deferring payments on any outstanding preferred securities. In other words, payments on preferred securities must come before payments to common stock; hence the name "preferred."
Like bonds, but unlike common stocks, preferred shares generally carry a credit rating from a recognized rating agency. It's worth noting that a company's preferred securities will usually have a lower rating than the firm's individual bonds.
Types of preferred securities
There are several varieties of preferred securities and the terms used to describe them can be complex. Here are the primary types, beginning with those that have the weakest guarantees:
1. Preferred stock can be considered the most "traditional" type of preferred security, representing ownership in the issuing company. Unlike an issuer's common stock, preferred stock has a fixed par value. Dividends may be suspended at any time and are generally not cumulative, meaning they don't need to be paid back if they are deferred. As equity securities, the coupon payments of some of these preferreds may receive advantageous tax treatment such as eligibility for qualified dividend income treatment. This is one reason many individual investors have chosen preferred stock, historically; however, it's important to read the prospectus to understand whether the payments on any shares that you own are taxed at the qualified rate.
2. Hybrid preferred securities are next in line. In the firm's priority of payment scheme, hybrid preferreds generally rank below the issuer's senior unsecured debt, but above preferred stock. Examples of hybrids include capital trust securities and junior subordinated debentures. The interest payments can be deferred, and can be either cumulative or non-cumulative. If payments are deferred for cumulative preferred shares, the coupons accumulate and must be paid back later, short of bankruptcy or default. This adds a bit of extra protection for investors, as well as incentive for the issuing companies to keep making payments, since they know they'll have to pay them eventually.
"Non-cumulative" means that if payments are deferred, they don't accumulate and won't be paid back later. This is a particularly unattractive feature, warranting higher yields for investors. Also keep in mind that deferred payments from hybrid preferreds can generate a "phantom" income tax, which makes the holder liable for income not yet received. Hybrid preferreds tend to pay interest, not dividends. They usually have fixed maturity dates (though generally long), compared to preferred stock, which is perpetual by nature.
3. Baby bonds, or senior notes, are just that: senior unsecured obligations of the issuer. Like bonds, they pay interest, and any missed payments constitute a default. Unlike bonds, they usually have a par value of $25 instead of $1,000, and they usually trade on an exchange. Despite their $25 par value and association with other preferred securities, these securities offer the same guarantees that senior unsecured bonds offer.
Typical preferred security structures
Source: Schwab Center for Financial Research
Why do companies issue preferred securities?
Companies generally issue preferred securities for flexibility. The primary issuers tend to be financial firms, such as banks or real estate companies, which need easy access to debt markets to operate. But other companies, such as utilities and industrial companies, often issue preferred securities as well. Preferred securities provide these companies with flexibility as an extra financing tool in addition to common stock and more-traditional corporate bonds.
Banks, which have strict regulatory requirements, are also able to use preferred securities as a source of capital "cushion" between their bonds and common stock. Bank regulations require certain levels of capital reserves, and preferreds can help meet that objective. The degree of capital treatment varies depending on the type of preferred security.
Preferreds do come with additional risks
Higher yields may be appealing, but they almost always come with the additional risks described below. However, lower yields that other investments offer can also be risky—in terms of maintaining purchasing power, meeting living expenses and so on. So there are tradeoffs. Which risks are most important to you?
- Sector concentration in banks and finance companies. One issue to consider when choosing preferreds is how they tend to be dominated by financial companies and banks (although real-estate firms can be heavy issuers as well). If you buy individual preferreds, this can lead to inadvertently concentrating your portfolio in specific financial firms as well as in the financial sector as a whole. When investing with individual preferred securities, we suggest limiting exposure to any single issuer to no more than 10% of your portfolio.
- Lower credit ratings than the issuer's bonds. An issuer's preferred securities will usually have a lower rating than the firm's senior, unsecured bonds. Also, preferred securities are often compared to sub-investment grade, or high-yield, bonds, given the higher income opportunities. But remember, high-yield bonds, by definition, carry speculative-grade ratings, so they do come with credit risk. Investors who research carefully can still find preferred shares from investment-grade companies, thus providing higher credit quality than junk bonds.
- Long duration and interest-rate risk if interest rates increase. Preferred securities usually have long maturities—often 30 years or longer—or even no maturity date at all, meaning they can remain outstanding in perpetuity. They generally are "callable," meaning they can be retired prior to maturity at a specified price after a specified date. But the option of the issuer to call is just that—an option. Given the option of the issuer to call these securities, pay attention to the price paid for the preferred. If a preferred security is bought at a price above its par value, but then the issuer calls the issue at par, the return, or yield-to-call, may be lower than originally anticipated.
Despite their callable nature, preferred securities should be viewed as long-term investments, and that means they are generally more sensitive to interest-rate risk if rates rise. If rates do rise, the price of preferred securities may fall, and fall further than the prices of shorter-term bonds, all else being equal. One final consideration is that certain types of preferred securities may be less liquid than other securities issued by the same firms.
Overall, investors with higher appetites for credit risk may consider allocating up to 20% of their overall portfolio to more aggressive fixed-income types. This more-opportunistic allocation could include preferred securities, high-yield bonds, emerging-market bonds or other sectors with greater credit or interest-rate risk.
Again, preferred securities may not be appropriate for all investors. Those who do choose them should learn about some of the risks and use them strategically as a higher-risk part of their income portfolio.
Find out more about individual preferred securities
Finding good information about preferred securities can be difficult, and there are many details to understand before investing. The best source of information will always be a security's prospectus, which you can obtain from a Schwab fixed income specialist, or from data repositories available online. Schwab clients can access our Preferred Stock Screener.
Don't just screen for the highest yields—also screen based on attributes such as credit rating, and then augment it with more information about the issuing company, the security listed, specific characteristics of the preferred shares (whether they coupon payments are cumulative or non-cumulative, for example, which is often listed in the security description) as well as call dates and other details. Don’t just look at the issue’s current yield—if a preferred is priced above par, it’s important to find out its yield-to-call. A fixed income specialist can help identify that yield.
If you'd like a diversified solution without too much exposure to any single preferred stock or issuer, consider preferred-stock exchange-traded funds (ETFs) or mutual funds. Clients can search for “preferred stock” funds in the “taxable bond” category using the Schwab ETF Screener or the Schwab Mutual Fund Screener.
¹ Par value, also known as face value, is the amount the issuer promises to pay the bondholder when the bond matures.
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