Preferred securities, also referred to as “preferreds,” appeal to investors seeking higher yields, which typically come with higher risks. Preferred securities often have very long (40-year) or perpetual maturity dates and many are structured with five-year calls (the issuer has the right to redeem it after five years). They are also subordinate to debt securities but are placed ahead of common stock in the corporate structure. And they may provide higher income than typical debt.
Most preferreds are listed like stocks, with the majority trading on the New York Stock Exchange. Like traditional bonds, preferreds tend to have credit ratings, and upgrades and downgrades often play an important role in secondary market pricing. Preferred credit ratings tend to be one to two notches below a corporation’s debt rating.
In general, there are three types of preferred securities, each of which share characteristics of both stocks and bonds: equity preferreds, trust or hybrid preferreds, and debt securities.
- Equity Preferreds – Traditional or equity preferred stocks are similar to common stock in that they are perpetual and never mature. Like bonds, most pay fixed payments, however, the payments are dividends rather than interest.
- Trust or Hybrid Preferreds – These may pay interest like bonds, however, those payments may be deferred or even eliminated under some circumstances without constituting a default event. Unlike bonds, many have a par value of $25, although some have $1,000 par value.
- Debt Securities – Often referred to as "baby bonds" due to their par value of $25, they pay interest like traditional bonds. Since they are debt, they stand ahead of equity preferred securities in the payout hierarchy should a company default. Debt preferreds may be secured, unsecured, senior, junior or subordinated in standing within the capital structure.
Potential investors should examine the characteristics of each issue to determine that the investment meets their expectations and risk tolerance. They should understand the capital structure for priority of claims, study call provisions and know the circumstances under which the issuer can stop making payments as well as what the consequences are.
- Income – Preferred securities generally offer fixed periodic payments. However, payments can be interrupted under certain scenarios that are discussed in Features, Considerations and Risks.
- Competitive Returns – Preferred securities may offer attractive yields compared to other fixed income investments.
- Term – Some preferred securities carry a defined investment time frame; however, many issues are perpetual. Usually, the investor has call protection for five years from the issue date, although extraordinary calls may exist, allowing the issuer to call the issue at any time.
- Quality – Preferred issues are generally rated by the rating agencies based on the issuer’s credit quality. In general, higher yields are associated with lower quality issuers. In the capital structure, they usually fall at the bottom of the balance sheet ahead of common stock but subordinate to debt.
- Liquidity – Most issues are traded on the major exchanges.
- Denomination – Most issues are offered in $25 par value denominations, although some are offered with $1,000 par value or other values.
Preferred securities are most suitable for investors with long-term time horizons who are interested in a fixed rate of return. As new structures continue coming to the market, not all issues may be suitable for a particular investor. The following explanations should be used in conjunction with a prospectus, as features may differ from issue to issue.
Preferreds at a Glance
|Traditional Preferred||Trust Preferred Security||Debt Security|
|Priority of claim||Junior to all debt, senior only to common equity||Junior to all debt, senior to traditional preferred and common equity||Senior to trust and traditional preferreds and common equity|
declared by the board of directors
|Cumulative or non-cumulative||
Cumulative or non-cumulative;
|Few permit deferral of income, but at some point the event may cause default|
|Paid out of after-tax earnings||Paid out of pretax earnings||Paid out of pretax earnings|
|Term||Perpetual||Usually 30 years or longer;
some issues have extendable features
|Usually 30 years or longer|
|Usually five years non-call from issue date||Usually five years non-call from issue date||Usually five years non-call from issue date|
|Special calls may exist||Special calls may exist||Special calls may exist|
Features, Considerations and Risks
- Returns – To evaluate the attributes of preferred securities, an investor must understand the pricing mechanism. These securities trade at a price that can include up to three components: par value, accrued dividend or income from the last payment date, and market premium or discount. As with bonds, preferreds should be evaluated based on the worst-case scenario. If purchased at a discount, current yield or yield to maturity are of significance. Yield to call is significant if preferreds trade at a premium as the issuer is more likely to call the security prior to its term. At par, the yield is typically the payment rate.
- Income – All preferred securities have an income feature based upon par value that is paid monthly, quarterly or semiannually. In simplest terms, traditional preferreds pay dividends, while trust preferreds typically pay interest; however, these income payments are dependent on the issuer’s financial condition. The issuer will generally have to stop paying the common stock dividend before it would stop the payments on preferreds. For traditional preferred stock dividends, the payments must be declared by the board of directors. The deferrable feature on certain trust preferred shares may have an unfavorable impact on investors' tax liability. On trust preferreds or capital trust structures, the issuer may defer payments up to five years, 10 years or longer without causing a default event. If deferred, the holder is liable for tax on income accrued but not received. Preferreds can also be cumulative or non-cumulative. In these instances, if the issuer stops making payments, cumulative shares will have to catch up and pay dividend or interest payments. Deferrable issues may have an alternative payment mechanism or provision that requires the issuer to sell assets to pay the deferred payments after a certain period. Some issues have a fixed to float feature. A fixed coupon (often five years) is typically followed by a coupon set to float at a margin above a specified benchmark index for the remainder of the security’s life. Changes in income payments may significantly affect yield and final term of the investment and, consequently, the price is subject to change.
- Term of Investment – Most preferred securities carry maturities of 20 to 49 years from the original issue date or are perpetual. While most preferred securities become callable after a period of call protection, certain extraordinary events may alter the term of investment. Special event calls may be in place to allow the issuer to call the securities early and may include a tax law change, capital treatment event (CTE)1, rating agency event or a regulatory call based on change in status of the issuer or a call on the underlying collateral. Further, a few issues with a defined maturity date may have provisions for maturity extension. These features are discussed in the prospectus and should be reviewed carefully as they may impact the final realized return.
- Credit Risk – The yields offered will depend upon the issuer’s credit quality. In general, lower credit-rated issuers provide higher yields to compensate for additional risk. If the issuer’s credit quality changes, the security’s value could be affected as well. Preferred securities rank low in priority in the corporate structure, higher only to common stock.
- Priority of Claim – Preferred securities provide the investor with a higher priority of claim on the assets than common stockholders should the issuer be liquidated. The priority in the capital structure of a corporation is as follows: (1) secured debt, (2) unsecured debt, (3) unsecured subordinated debt, (4) trust preferred securities, (5) traditional preferred stock and (6) common stock.
- Interest Rate Risk – Preferred shares are fixed income securities that, like bonds, have values that rise and fall in response to interest rate changes. Principal is subject to market fluctuations, which can be significant at times, and sale proceeds may be more or less than the original purchase price. Preferred securities typically have long-term maturities where an increase in interest rates can have a considerable impact on the principal value. If rates rise, preferred prices typically decline. Conversely, when interest rates decline, the income rate available on a previously issued preferred generally becomes more attractive, and demand can drive the price up. However, if the securities are callable, a decrease in interest rates may not have as much impact, given that issuers are more likely to call securities in a decreasing interest rate environment. In addition, preferred securities trade at a price that includes income accruals. All other variables being equal, the preferred price should increase accordingly to reflect the accrued income. Other factors affecting the price include supply, demand, credit risk and structure.
- Liquidity – Most preferred issues are traded on a major national exchange and are quoted in many major media sources with a “pf” following the underlying stock symbol.
- Taxation – Only some traditional preferred stocks of domestic corporations carry dividend received deduction (DRD) under which “qualified” corporations may receive a tax advantage. For other preferred securities, there is no tax-advantage for qualified domestic corporations. Based on current tax law, certain types of preferreds may qualify for qualified dividend income (QDI). However, investors should not rely on this provision, as it may change. Investors are urged to consult with their own tax advisors with regard to their specific situation prior to making any investment decisions with tax consequences. As discussed above, the deferrable feature on certain trust preferred shares may have an unfavorable impact on an investor's tax liability. On trust preferreds or capital trust structures, the issuer may defer payments up to five years, 10 years or longer without causing a default event. If payments are deferred, the holder is liable for tax on income accrued but not received.
- Diversification – Although a diversified portfolio including preferred securities may help to reduce risk and mitigate the effects of market volatility, diversification in itself does not ensure a profit or protect against a loss. Investments are subject to market risk, including possible loss of principal.
1 An example of a Capital Treatment Event (CTE) occurred as a result of rules approved by the Federal Reserve’s Board of Governors after Congress passed the Dodd-Frank Act. The release of Notices of Proposed Rulemaking (NPR) allowed certain banks to redeem some of their outstanding trust preferreds at par plus any accrued interest within a 90-day period. In this instance, some banks interpreted the initial passing of Dodd-Frank as a CTE, others viewed the release of the Notices as the CTE and still others viewed the actual implementation of the rule as a CTE. As such, it is difficult to determine when or why an issuer may call its securities.
Investing involves risk and you may incur a profit or a loss. The value of fixed income securities fluctuates, and investors may receive more or less than their original investments if sold prior to maturity. Bonds are subject to price change and availability. Investments in debt securities involve a variety of risks, including credit risk, interest rate risk and liquidity risk. As a general rule, the price of a bond moves inversely to changes in interest rates.
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