Learn why some investors are turning to preferred securities for tax-advantaged income.
Preferred stock, a kind of hybrid security that has characteristics of both debt and equity, is attracting more interest from investors who are seeking higher-yielding investments in the current low interest rate environment. Mainly issued by financial institutions, preferreds have several advantages as well as some risks to be aware of.
Bank preferreds are usually issued with yields that are well above other high-quality income vehicles. In March 2020, the Federal Reserve lowered the target rate for Fed Funds to 0-0.25%. Since then, the Fed has reiterated the likelihood rates can remain lower for longer. As such the potential income generated from preferreds may seem even more attractive to investors. While the 10-year Treasury currently has a yield of about 0.75%, many preferreds currently offer yields of around 4%.
Supply and demand dynamics are a notable positive for bank preferreds at this time. After the financial crisis of 2008, banks issued a significant amount of preferreds to meet the new higher capital levels required by regulators. Now that many of those needs have been met, issuance has slowed. This has created a very positive technical backdrop for preferreds.
Tax treatment is another major advantage. While most investors, when looking for tax-advantaged investments, migrate to the tax-free municipal market, most preferreds offer tax-advantaged income in the form of qualified dividends. Qualified dividend income, which is taxed at the lower long-term capital gains rates (0% to 23.8% depending on an investor’s tax bracket), can offer an after-tax yield pickup versus traditional corporate bonds, where the interest is taxed at ordinary income rates (up to 40.8% currently). This creates a significantly higher taxable equivalent yield: An investor in the top tax bracket must earn 5.15% in a corporate bond to match the after-tax yield of a 4% preferred (the difference between the top income tax rate versus the long-term capital gains rate that applies to qualified dividends). Each preferred stock issue has a prospectus that details the structure, helping an investor to determine the taxable nature of its dividends.
Bank preferreds have higher yields mainly because they sit lower in the bank’s debt capital structure. While preferred stock is senior to common equity on a bank’s balance sheet, it falls below all other creditors, including subordinated or senior unsecured debt. The risk is that in a bank liquidation, preferred shareholders would get little to nothing in recovery. This is known as subordination risk.
A key risk investors need to be aware of is duration risk. While preferreds are typically issued with five- or 10-year call provisions, they are perpetual in nature (no final maturity date). With many preferreds now trading above par and rates near historic lows, its important investors consider this risk, in the event rates rise or spreads widen.
“Structurally, preferreds can come with varying degrees of call protection and coupon schedules,” notes Paul Servidio, a Managing Director and head of Morgan Stanley Wealth Management Fixed Income Sales. “It’s important that investors understand what they are buying and why.”
Investors who want to mitigate duration risk can invest in what are known as fixed-to-floating rate or fixed-to-rest preferreds. These preferreds pay a fixed coupon for a set period of time. Then, if not called, the coupon floats or rests to a fixed spread over a named benchmark; London Interbank Offered Rate (Libor), Secured Overnight Financing Rate (SOFR) and Constant Maturity Treasuries are the most common (for information on the transition away from LIBOR and the recommended alternative rate, SOFR, contact your Financial Advisor). Many of these securities have a par value of $1,000 and have traditionally been an institutional only product, but they are increasingly available to individual investors as well. In all, these securities account for nearly 85% of the total $1.1 trillion hybrid market.
A final risk worth mentioning: As most preferreds mainly pay dividends, not interest, the issuer has the ability to turn off the coupon indefinitely if its capital levels fall dramatically. Note, however, that this normally happens only if that issuer first eliminates its common dividend (generally not something a bank wants to do). This outcome seems unlikely in the near term as the banking sector remains soundly profitable and well capitalized with common equity.
In the aftermath of the financial crisis banks were required to significantly bolster their capital positions, creating a much stronger fundamental backdrop in the preferred space. “The strength of the financial sector now is a big reason we are comfortable suggesting that certain investors can consider moving down the capital structure with bank preferreds,” says Servidio.
Bank capital was in the spotlight again this year, as the pandemic-driven recession had investors asking how safe U.S. bank dividends were. “U.S. banks reacted quickly to the economic destruction and uncertainties by suspending buybacks. The Fed followed later in the year by instituting a cap on common dividends,” says Servidio. “Despite these concerns, and because of the swift action taken by both bank leadership and the Federal Reserve, U.S. bank preferred dividends were never really in danger of being disrupted.”
To learn more about preferred securities and how they might fit into your broader portfolio strategy, speak with your Morgan Stanley Financial Advisor (or find a Financial Advisor near you using the locator below).