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.

Preferred securities lie between common stock and bonds in a company’s capital structure. If the issuer goes bankrupt, the preferred shareholders stand ahead of the common stockholders but behind senior debt holders in the payback line—presenting subordination risk that partly explains preferred securities’ higher income. Preferred payments are also subject to deferral or outright omission, although such actions are extremely rare in practice, typically occurring only in cases of significant corporate stress.

Given the technical possibility of an omitted payment, investors demand high-quality, tested and stable business models to provide an adequate comfort level around expected income. It’s no coincidence, therefore, that preferreds are issued mainly by large, highly regulated institutions and/or companies with steady and transparent cash flows such as banks, insurance companies, utilities, telecommunication companies and real estate investment trusts. In fact, investors will find little in the way of cyclical or smaller companies in the preferred universe in general.

Preferreds Active Managers Have A Decided Edge Over ETFs

To our continued bewilderment, investors seeking access to preferred securities have heavily favored ETFs over actively managed funds. Flows into preferred ETFs dominated those of open-end mutual funds by 3 to 1 in 2015. The shift toward passive vehicles is understandable for some investments. But preferred securities are one asset class where this approach makes no sense, in our view—for very clear reasons.

Preferred ETFs invest only in $25-par exchange-listed securities, which represent less than one quarter of the nearly $1 trillion global preferred securities universe. By contrast, certain actively managed funds may also invest in the much larger institutional OTC market, which offers a far wider array of issuers and security structures, including numerous overseas opportunities. ETFs’ narrower focus not only limits their holdings, but precludes them from many new investment opportunities, since the vast majority of new preferred securities being brought to market today are being issued into the OTC market.

Importantly, active managers also have the ability to dynamically position a portfolio based on their outlook for the economy and interest rates. Active managers conduct fundamental credit analysis to identify securities that offer attractive yields and/or company-specific catalysts that could result in tightening credit spreads and ratings upgrades. Managers also have a variety of tools to manage a portfolio’s interest-rate risk—for example, by concentrating assets in lower-duration securities.

While different investors have different needs, we believe there are material reasons to consider the advantages of working with an active manager who specializes in preferred securities, particularly at a time of heightened economic uncertainty.

Mitigating Interest-Rate Risk With Low-Duration Preferreds

Investors whose primary experience with preferreds is through ETFs may perceive that preferreds are highly sensitive to longer-term interest rates. This is because the exchange-traded market is dominated by securities with fixed-rate structures, generally giving them a high duration. (Duration is a measure of an asset’s sensitivity to changes in interest rates, or yields. The higher the duration, the greater the price will change in response to a given rise or fall in interest rates.)

By contrast, the institutional OTC market is composed primarily of lower-duration fixed-to-floating rate preferred structures. These securities typically pay a fixed coupon for a certain period—often five or ten years—and then convert to a floating-rate structure, drastically reducing their interest-rate sensitivity compared with fixed-for-life structures.

The opportunity set of low-duration preferreds is quite large, with more than $500 billion worth of preferred securities featuring durations of five years or less. We believe that access to both the exchange-traded and OTC markets is essential over the course of an interest-rate cycle, as some securities will fare better than others depending on market conditions.

The Tailwind Of Global Financial Reform

In the aftermath of the financial crisis, stricter banking and insurance regulations enacted in the United States and elsewhere have forced many institutions to shore up their balance sheets and reduce business risks. These financial reforms are not only driving stronger credit fundamentals for preferreds, but have also spurred a global wave of refinancing opportunities as companies redeem old-style preferreds that no longer qualify as Tier-1 equity capital and issue new preferreds that count toward their regulatory capital requirements.

One new structure inspired by stricter regulation is the contingent capital, or CoCo, security, which has become the new standard for many foreign banks. Unheard of just a few years ago, the CoCo market has grown exponentially and now represents over 15 percent of the global preferred security universe, with large European banks being the most prevalent issuers. CoCos differ from other preferreds in that they have explicit loss-absorbing mechanisms triggered by large changes in regulatory capital. Compensating investors for their unusual features and abundant new supply, CoCos offer investors comparatively high yields and can represent an appealing opportunity for investors who can assess and manage their risks.

Attractive Qualities For Today’s Challenges

As investors search for answers on how to generate high and stable income while navigating higher interest rates and turmoil in high yield, we believe preferred securities are well positioned for the current environment. With further rate hikes on the horizon, the high income levels and low duration structures offered by many preferred securities may help protect investors from a total-return perspective. Yield premiums relative to Treasuries are also well above what they were before the financial crisis, which can provide a cushion against the effect of rising rates.

What is more, unlike the deteriorating fundamentals in the high-yield sector, balance sheets for many preferred securities issuers are as strong as they’ve ever been—and getting stronger with high regulatory hurdles set for the years ahead. As companies continue to bolster their capital in line with rising regulatory requirements, this could lead to tighter spreads and credit ratings upgrades, ultimately buoying the price of preferred securities.

As always, investors should consider the risks of any investment. If interest rates rise significantly, preferred securities may lose value. Preferreds are also sensitive to forces that affect credit markets broadly. But when viewed in the context of a diversified portfolio, we believe preferred securities offer a compelling combination of high income and diversification potential, backed by a strong track record of positive returns in a variety of market environments.

William Scapell, CFA, is executive vice president at Cohen & Steers and the firm’s director of fixed income.