Investors face a difficult decision as they approach fixed-income allocations in 2016. Barring an economic slump, the Federal Reserve is on track to slowly raise interest rates, potentially creating headwinds for fixed income total returns. Meanwhile, the trouble in high-yield corporate debt may be just beginning as weakness in commodities continues to wreak havoc in the energy sector, leading to rising defaults and diminished liquidity across the high-yield space.
In the search for alternatives, many investors have turned to preferred securities. According to Morningstar, open-end mutual funds and ETFs focused on preferred securities saw about $6 billion in net inflows in 2015, contrasting with the net outflows seen in certain other fixed income categories. The appeal of preferreds stems from several qualities that seem particularly attuned to the current market environment.
Preferreds currently offer the highest income rates in the investment-grade fixed income universe, generally in the 6 percent range. This puts them well above yields for corporate bonds, municipals and Treasury securities.
Preferreds also have a compelling performance track record. Since 2000, preferred securities have generated positive total returns every year except 2007 and 2008 (as measured by a 50/50 blend of the exchange-traded and over-the-counter (OTC) preferred securities indexes). Even in difficult periods for the broader bond market—such as 2013, when Treasury yields spiked in anticipation of tighter monetary conditions—the high income rates offered by preferred securities helped buffer the negative effects of rising long-term interest rates.
The most common issuers of preferred securities—banks and other financial institutions—have seen steadily improving credit fundamentals over the past few years. This has been largely the result of stricter regulations, which have forced them to shore up their balance sheets and reduce operating risks. Bank regulatory requirements are set to continue to rise over the next few years, offering a continuing tailwind for the preferred securities market.
Furthermore, the preferred securities market has almost no direct exposure to energy and commodities companies. These recently volatile segments account for nearly 15 percent of both the high-yield and corporate bond classes. The low sector overlap with other fixed-income categories means that preferred securities may help to diversify sources of risk.
What Are Preferred Securities?
Preferred securities play a unique role in capital markets. For the entities that issue them, preferreds are a form of equity, enabling companies to achieve capitalization levels required by regulators and ratings agencies. For investors, preferreds act like bonds, simply offering a fixed or floating rate of income. Their prices are not tied directly to earnings as is the case with common equity, but instead, fluctuate with changes in prevailing interest rates or with changes in the issuer’s credit quality.
The dividends on preferred securities are usually paid quarterly or semi-annually and typically exceed what investors can get from a company’s common stock or straight bonds. The income from preferreds is taxable, but is often eligible for taxation at the favorable qualified dividend income (QDI) rate—the same rate investors pay on long-term capital gains—depending on the security. The net income advantage can be quite material for top tax bracket investors, as the QDI tax rate is about 40 percent lower than the ordinary income rate.