Preferred securities are investments that are popular with investors looking for a source of safe and steady income. It is a hybrid security, blending characteristics of both stocks and bonds.
What Are Preferred Securities?
Preferred securities are fixed-income investments with equity-like features. Many of them are issued by large banks and insurance companies.
Some of the key differences between common and preferred stocks include: preferred stockholders having a higher claim on distributions (dividends) than common stockholders; preferred stockholders usually have no or limited, voting rights in corporate governance; and, in the event of a liquidation, preferred stockholders’ claim on assets is greater than common stockholders but less than bondholders.
Here are some of the common characteristics of preferred securities:
Price and Yield: preferred stock shares are issued at a $25.00 price with a set yield. In order to get the annual dividend rate, multiply the yield times the share price.
Perpetual, but Callable: most preferreds are issued as perpetuals (they have no stated maturity date), but the issuer will have an option to “call”, or redeem the stock at a fixed value, before the maturity date – usually at 5 or 10 years after issuance.
Fixed and Floating Rates: preferreds with more debt-like traits can have fixed rate, floating rate, or fixed-to-floating rate dividends. Floating rate structures offer much lower interest rate risk than fixed rate bonds.
Cumulative or Non-Cumulative: deferred or missed payments on cumulative preferred securities accumulate as obligations of the issuer, and must be paid out to holders of preferred securities before common shareholders can receive any dividend payments. However, with non-cumulative preferred securities, missed payments do not accumulate as obligations of the issuer and shareholders are not entitled to receive missed payments.
High Quality Ratings: preferreds are often issued by investment grade entities, and even though they are typically ranked two or more notches below an issuer’s senior debt, many preferreds still garner investment-grade ratings.
Distributions are dividends, not coupon payments: preferreds pay dividends on a fixed schedule, rather than coupons like a bond. And in periods of severe financial stress, the issuer may skip a payment without triggering a default. Income earned from preferreds are usually taxed at a federal rate which is considerably less than ordinary income tax rates that are applied to other fixed income securities.
Junior Capital Structure Ranking: preferreds rank lower than senior debt, but higher than common stock in a company’s capital structure. That means, in the event of an issuer’s default, investors holding that company’s preferreds will get paid back after the bondholders and before the stockholders.
Why Invest in Preferred Securities?
While preferreds are stocks, they are vastly different from common stocks. So don’t get them confused. . .they’re a world apart when it comes to risks and rewards.
In brief, preferred stocks can make an attractive investment for investors seeking steady income, with a higher payout than they’d receive from common stock dividends or bonds. However, these investors may miss out on the upside potential of common stocks and the safety of bond payments.
In an environment of low interest rates and rising volatility, preferred securities are attractive because of their historically high relative yields and their ability to weather changing interest rate environments. They also may help diversify a fixed income portfolio, due to their historically low correlation to other bond and stock asset classes.
And since preferreds are predominantly investment grade securities, it helps investors manage their portfolio’s credit risk.
In addition, there is tax-advantaged income potential, since many preferred security structures pay qualified dividend income (QDI).
A few firms issue convertible preferred securities. They can typically be exchanged for a specified amount of a different security, often the common stock of the issuing company. Convertible preferred securities may combine the fixed income characteristic of bonds with the potential appreciation characteristics of stocks. There are often provisions attached to convertible preferred securities that place restrictions on when they can be converted. Since convertible preferred securities can be exchanged for shares of the issuer’s common stock, the value of these securities will be more volatile than your typical preferred security.
How to Participate in Fixed Income Investing/preferred Securities
Preferred securities, like other stocks and fixed income securities, can be purchased through your brokerage firm.
However, keep in mind that no two preferred securities are alike. So take the time to read the ‘fine print’ and determine whether a particular preferred issue aligns with your investment needs, risk tolerance, and goals.
Another aid for investors – either to find preferred securities, ETFs or funds, or even individual preferred stocks – is to check the Magnifi website under preferred stocks.
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The information and data are as of the February 9, 2022 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.
