For better or worse, the Chinese saying, “May you live in interesting times,” certainly applies to the present. Aside from geopolitical events at home and abroad, investors are understandably concerned about risks related to interest rates, inflation and market volatility. In the wake of worry over interest rates and inflation across the short and medium terms, many financial advisors seek asset classes that are capable of delivering the income their clients need, while minimizing risk.
Low-duration preferred securities and hybrid debt can potentially play a vital role within investment portfolios during the current market by providing the potential for high the monthly income and mitigating interest-rate, duration and other investment risks.
A Different Kind of Asset
Preferred securities and hybrid debt are hybrid securities that embody characteristics of both equity and fixed-income securities. Like common stock, they can increase or decrease in price and represent shares of company ownership. But like traditional bonds, they offer a floating or fixed dividend similar to a coupon.
Preferred securities and hybrid debt fall between corporate bonds and common stock in a company’s capital structure. While they may have lower credit ratings because they fall below corporate bonds in the capital structure, investors who hold preferred securities are often compensated for that extra credit risk—giving them access to potentially higher yields than comparable investment-grade corporate bonds. Preferred securities often come with embedded call and reset features that enable the issuer to redeem them, or reset rates, in response to events in the marketplace.
Furthermore, their rank in the corporate capital structure above common stock means that investors holding preferred securities take priority over common stockholders as claimants in the event of liquidation or bankruptcy.
The Role They Play In A Portfolio
Investors most often seek out preferred securities and hybrid debt because they have the potential deliver higher income than traditional fixed-income investments with similar ratings, including municipal bonds and corporate bonds. But that’s not their only attribute.
These securities’ hybrid characteristics can give them a low correlation to traditional asset classes, which could strengthen portfolio diversification.
In addition, the majority of preferred securities’ income is classified as qualified dividend income, and these distributions are taxed at long-term capital gains rates—which are lower than the tax rates applied to ordinary income.
Besides diversification and tax-efficient income, many preferred securities are currently trading at an 8% to 15% discount to where they usually trade due to the regional banking crisis we experienced last year. This discount won’t last forever, but while it does, it presents investors with an opportunity to obtain tax-efficient income with a potential for capital appreciation as well.
Lower Duration Is Key
While preferred securities and hybrid debt offer many attractive benefits, they can come with risks, just like any other investment. Preferred securities are longer dated securities, and many don’t mature at all. As such, preferred securities can heighten interest-rate risk for investors.
By steering investors toward investment strategies that focus on preferred securities that have durations of five years or less and exhibit low correlations to traditional assets, advisors can potentially help mitigate interest-rate and downside risk without sacrificing elevated levels of tax efficient income.
As of December 31, 2023, low-duration preferred securities, as represented by the ICE Exchange Listed Preferred & Hybrid Securities Index, generated an effective yield of 6.19%. The asset class outperformed investment-grade corporate bonds (5.14%), as represented by ICE Bank of America U.S. Corporate Index, as well as U.S. Treasuries (3.89%) and municipal bonds (2.86%), as represented by the ICE BofA 7-10 Year U.S. Treasury Index and ICE U.S. Broad Municipal Index, respectively (Source: ICE Data Services).
Focusing on preferred securities with lower durations could give investors the same benefits of what can be considered a risky asset class—potential for higher income, tax efficiencies, diversification and potential for capital appreciation—while minimizing exposure to interest rate risk. As we continue to see interest rates remain rather volatile, advisors can demonstrate value by providing investors with access to a more stable approach to navigating present market conditions.
Lance McGray is managing director and head of ETF product at Advisors Asset Management.