Are Preferred Securities Still Attractive?

March 28, 2024 Collin Martin
Our outlook is still positive, but it may be difficult to replicate the strong returns of the past few quarters.

Preferred securities have been one of the best-performing fixed income investments over the past six months, aided by lower long-term Treasury yields and the general "risk-on" theme that has propelled many stock indexes to all-time highs.

Our outlook is still positive, but it may be difficult to replicate the strong returns of the past few quarters going forward. We don't necessarily expect prices to fall—they should be range-bound for the near term—but investors should focus more on the high income offered by preferreds rather than the potential for more near-term price appreciation.  

We see both benefits and risks with preferred securities today:

Benefits:

  • High income
  • Potential tax benefits
  • Attractive entry point relative to history for long-term investors

Risks:

  • Low relative yields
  • Price appreciation may be limited over the short run

High income payments and yields are key benefits of preferred securities for income-oriented investors. Since preferred securities are a type of hybrid investment that shares characteristics of both stocks and bonds, they tend to offer high yields to compensate for heightened risks and additional complexities.

Yields have risen sharply over the past few years and the ICE BofA Fixed Rate Preferred Securities Index now offers an average yield-to-worst of more than 5.5%. That's off its recent high of 7.8% from last fall but is at the high end of the 10-year pre-pandemic range.

Preferred security yields are still at the high end of the pre-pandemic range

Chart shows the average yield to worst for the ICE BofA Fixed Rate Preferred Securities Index dating back to March 2010. Yield to worst rose as high as 7.8% in 2023 and was around 5.5% as of March 22, 2024.

Source: Bloomberg, using weekly data as of 3/22/2024.

Yield-to-worst is the lowest possible yield that can be received on a bond with an early retirement provision. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly.

Many preferred stocks pay qualified dividends that are subject to lower tax rates than traditional interest income. Investors considering preferreds relative to other investments should always consider what type of account they'll be held in—taxable or tax-advantaged—and if held in taxable accounts, the after-tax yield. Not all preferred stocks or securities pay qualified dividends—some pay interest—so it's important to know what you own and what the tax consequences are. Qualified dividends are generally taxed at 0%, 15%, or 20% rates, depending on income limits. Those lower rates can be an advantage for investors in high tax brackets.

The entry point is relatively attractive for long-term investors with the average price of the preferred index below $94. Keep in mind that most preferreds in the index have par values of $25, but the average price of the index is rebased to $100. Prices are relatively low given the rise in long-term Treasury yields over the past few years, since prices and yields move in opposite directions.

Preferred security prices are still below the pre-2019 levels

Chart shows the average price of the ICE BofA Fixed Rate Preferred Securities Index dating back to March 2011. As of March 22, 2024, the average price was $93.2.

Source: Bloomberg, using weekly data as of 3/22/2024.

Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly.

Although prices are low relative to history, there might not be much upside potential in the short run unless the downtrend in long-term Treasury yields resumes. Because preferred securities have long maturities (or no maturities at all), changes in the 10-year Treasury yield can influence the price and yield of preferred securities.

We see fair value for the 10-year Treasury yield in the 3.5% to 4% area, compared with its current yield of roughly 4.2%. That suggests there is room for yields to move lower from here, which could boost preferred security prices. However, the Federal Reserve has recently signaled that it may not cut rates until the second half of the year and there may be fewer cuts than previously expected. Those factors could keep the 10-year Treasury yield above 4% for the next few months, potentially limiting the potential price appreciation with preferred securities.

Since early 2010—and with the exception of the spike in 2020—the six-month rolling return of the ICE BofA Fixed Rate Preferred Securities Index has rarely topped 10%. The total return of the index through the six months ending March 22, 2024 was 10.7%, suggesting that there might not be much near-term upside if the historical relationship holds.

Rolling six-month total returns generally have not risen much more than 10%

Chart shows the six-month rolling returns of the ICE BofA Fixed Rate Preferred Securities Index dating back to March 2010.

Source: Bloomberg, using weekly data as of 3/22/2024.

Total returns assume reinvestment of interest and capital gains. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly.

Low relative yields are another reason to temper enthusiasm for preferred securities. The average yield-to-maturity of the ICE BofA Fixed Rate Preferred Securities Index is roughly 6.3%.1 We believe that's attractive on the surface, but it's not much of an advantage over the 5.5% yield of the Bloomberg U.S. Corporate "BBB" Bond Index.2 The average credit rating of that preferred security index is in the mid-"BBB" area, so comparing yields to BBB rated corporate bonds provides a more apples-to-apples comparison.

That 80-basis-point yield advantage that preferreds offer relative to similarly rated corporate bonds is low considering it averaged roughly 200 basis points from 2010 through 2019 (a basis point is one one-hundredth of a percentage point, or 0.01%). Given that relatively small yield advantage, in our opinion more-conservative to moderate investors should just consider investment-grade corporate bonds and the more than 5% average yields they offer rather than reaching for yield with preferreds today.

The extra yield preferreds offer relative to similarly rated corporate bonds has declined

Chart shows the average yield to maturity for the ICE BofA Fixed Rate Preferred Securities Index and the Bloomberg US Corporate BBB Bond Index. Preferreds offered an average yield of 200 basis points on average over BBB rated corporate bonds from 2010 through 2019, but that advantage is less than 100 basis points currently.

Source: Bloomberg, using weekly data as of 3/22/2024.

Bloomberg U.S. Corporate BBB Bond Index (LCB1TRUU Index) and the ICE BofA Fixed rate Preferred Securities Index (P0P1 Index). The Bloomberg U.S. Corporate BBB Bond Index is a subset of the Bloomberg U.S. Corporate Bond Index that reflects corporate bonds with BBB ratings. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. For illustrative purposes only. Past performance is no guarantee of future results.

What to consider now

Investors that are looking for income and are willing to take some risk for higher yields could consider preferreds, but investors with more-conservative to moderate risk tolerances might want to consider investment-grade corporate bonds instead. Investment-grade corporate bonds offer average yields of 5% or more with less credit risk than preferreds.3 For those considering preferreds, we always suggest that they be considered long-term holdings given their long maturities.

There are a number of ways to invest in preferred securities. Schwab clients can use the Preferred Shares Screener when looking for individual preferreds, or can explore funds on the ETF or Mutual Fund pages; preferred funds can be found under the Morningstar category of "Preferred Stock." You can also consider a separately managed account.

1 Yield-to-maturity was used in this example rather than yield-to-worst to smooth out the effects of call features for many preferred securities.

2 The Moody's investment grade rating scale is Aaa, Aa, A, and Baa, and the sub-investment grade scale is Ba, B, Caa, Ca, and C. Standard and Poor's investment grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C. Ratings from AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. Fitch's investment-grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C.

3 Source: Bloomberg US Corporate Bond Index average yield-to-worst of 5.3% as of 3/26/2024.