With yields of 6% or more, preferred securities have become a popular choice for yield-hungry investors willing to expand beyond plain vanilla bonds. Yet the hybrid nature of these securities often leaves investors pondering which side of the portfolio to put them on.

“Some people think of preferred securities as an alternative investment that falls somewhere between equity and debt,” says William Scapell, manager of the Cohen & Steers Preferred Securities and Income Fund. “I tend to view them as part of a fixed-income allocation because they are more like a bond than anything else.”

Often called preferred stock, preferred securities have characteristics of both stocks and bonds. Like bonds, they are sold at par value, and their prices fluctuate with changes in interest rates or upgrades and downgrades to a company’s credit ratings. The dividends on these issues, which are usually paid quarterly, typically exceed what investors can get from a company’s common stock or straight bonds. That income is subject to taxes, of course, at either the favorable rate for qualified dividends or at ordinary income rates, depending on the security. (About half the income generated by the fund last year was eligible for taxation at the favorable qualified dividend rate.)

The securities also lie between stocks and bonds in a company’s capital structure. If the issuer goes bankrupt, the preferred shareholders stand ahead of common stockholders but behind senior debtholders in the payback line. A company running short on cash would stop the income spigot to common stockholders before ceasing payments to preferred stock shareholders. Senior debtholders would be the last to feel the pinch.

A Better Value Than Bonds
Scapell believes that even though preferred securities have been discovered by more people over the last few years, they remain one of the few values left among income-oriented investments. They have a yield advantage of about 400 basis points over 10-year Treasury securities, well above the average 300 basis point spread over the last 15 years. Their yield spreads over investment-grade bonds are also currently high by historical standards.

“In our view, the difference in current versus long-term historical yield spreads suggests that preferred securities are relatively cheap,” he says. “And that yield advantage offers a potentially higher cushion against rising rates.”

He says below-investment-grade bonds are the closest relative to preferred securities because they offer high income and are senior to equity in the capital structure. But there are some important differences. While junk bond issuers come from a variety of industries, preferred securities are usually issued by banks and insurance companies. As a group, preferred securities have an average Standard & Poor’s credit rating of ‘BBB+’, which puts them at the lower rung of the investment-grade ladder, and a step or two above high-yield bond ratings.

Although ETFs have become a popular entry point into this market, Scapell cautions that this little-understood area isn’t one most financial advisors should tackle through individual securities or ETFs. Those investments typically draw from preferred securities that trade on the New York Stock Exchange. These represent less than one-quarter of the total preferred market, and they are highly susceptible to interest-rate risk because they have fixed dividends and no maturity dates. They also have call provisions that allow the issuer to redeem the securities after five years and issue new ones with lower rates.

By contrast, actively managed mutual funds also tap the much broader over-the-counter market, which is dominated by floating-rate securities—or securities that switch from fixed to floating rates after a specified number of years. This feature makes them less sensitive to changes in interest rates than exchange-traded fixed-rate securities.

The over-the-counter market is also home to a larger array of foreign issuers from both developed and emerging markets, which gives investors geographic diversity. Furthermore, the large institutional investors that dominate the over-the-counter space can negotiate favorable prices. Because of these advantages, about 70% of Scapell’s fund assets are in securities traded in the over-the-counter institutional market.

Active management has already paid off for shareholders in this fund, which marked its three-year anniversary earlier this year. As of May 31, it had posted an annualized return of 13.9% for the last three years, according to Morningstar, while the iShares S&P Preferred Stock Index ETF, the most popular exchange-traded fund of the genre, posted 10.16%. Within the broader long-term bond category, where Morningstar places it, it ranked No. 1 of 58 funds tracked over the three-year period.

The noteworthy performance of preferreds over the last few years stands in sharp contrast to their 2008 returns, when the financial institutions that dominated the market took a beating. Just before the fallout, preferred securities yielded a scant 225 basis points over long-term Treasurys because they were in high demand. But by March 2009, immediately after the financial crisis fallout, that spread had widened to a yawning 1,300 basis points.
Since then, yield spreads have narrowed considerably as investors scrounging for income have shored up prices by entering the market in increasing numbers through ETFs and mutual funds. At the same time, the financial picture for banks has seen marked improvement as financial regulations continue to force them to decrease leverage and shore up balance sheets.

Scapell cites fund holding Citigroup as an example of a large bank that is likely to see a credit upgrade over the next couple of years, which would benefit both bondholders and preferred security holders. Currently rated ‘BB’ by Standard & Poor’s, the 6% yield on the preferreds remains effective for the first 10 years, then floats after that. Developers Diversified Realty, a shopping center REIT that operates in the U.S. and Puerto Rico, is another fund holding that has deleveraged its balance sheet and improved its credit profile since the 2008 financial crisis.

Preparing For Rising Rates
Despite the improved finances of issuers, the past performance of preferred securities shows they can be sensitive to changes in interest rates. During the federal funds rate hikes from 1994 to 1995 and from 1999 to 2000, they posted modest total return losses. During the rate hikes from 2004 to 2006, however, their generous income payments offset principal losses, and they experienced a gain of around 9%.

According to a recent study by Cohen & Steers, the fluctuating financial fortunes of banks and insurance companies have made preferreds less sensitive to changes in interest rates and more responsive to the deteriorating or improving credit picture of the issuing companies. Since 10-year U.S. Treasury yields reached a low of 1.43% in July 2012, preferred securities and high-yield bonds have outperformed more interest-rate-sensitive Treasurys and municipals by a wide margin. Between the Treasury yield nadir in July 2012 and March of this year, preferred securities in the over-the-counter market saw total returns of 11%, while investment-grade corporate bonds logged 2.5% and the 10-year Treasury note fell 2.0%.

Scapell believes that the improving financial picture for banks and the potential for credit upgrades will provide a tailwind for the preferred securities market and the fund. New regulations governing banks, both in the U.S. and abroad, have already led to decreased leverage and healthier balance sheets.
“Banks are being forced to hold more capital than ever before,” he says. “I worked at the Federal Reserve for over six years doing bank supervision, and from what I am seeing, banks are far more stable than they have been in the past. Rating agencies tend to look in the rearview mirror. But eventually they won’t be able to ignore vast improvements in the capital structure and stability of earnings.”

Scapell cites a number of other ways the fund is managing interest rate risk. Most of the securities it owns have floating rates or fixed-to-floating rates. Because these securities typically have lower durations due to their floating rate component, they are likely to hold up better than straight bonds in a rising rate environment.

The fund has around 40% of its assets in securities rated just below investment grade, or that are not rated. The big yield advantage these securities have over Treasurys can help protect investors if interest rates rise, says Scapell.

About one-third of the fund is invested in foreign securities, which often have higher yields than those issued in the U.S. He cites fund holding La Mondiale, a French life insurance company with a ‘BBB’ rating that yields about 7.5%.

The foreign component provides a hedge against interest rate risk, since economic recoveries and interest rate cycles vary among countries. The U.K. and Europe have much weaker economies and are plagued by government austerity, so Scapell believes they are less likely than the U.S. to see rising rates in the near future. About 12% of the fund is invested in securities issued by companies in the U.K., which has the most established preferred market in Europe. The Netherlands and Switzerland represent 5% and 4% of the fund’s assets, respectively.

While the fund is prepared to meet the challenge of rising rates, Scapell believes that the slow pace of economic growth, particularly in Europe, makes a sharp upturn unlikely. “Rising rates are not imminent,” he says. “But it’s still prudent to be prepared.”