Preferred Securities
Preferred securities possess certain characteristics shared by stocks and bonds. They often have very long (40+ years) 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.
Most preferreds are listed like stocks, with the majority trading on the New York Stock Exchange. Preferred are reviewed by the major credit rating agencies that tend to rate them credit ratings tend to be 1 to 2 notches below a corporation’s debt rating.
In general, there are two types of preferred securities, each of which share characteristics of both stocks and bonds: equity 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 which is taxed at a typically higher ordinary income tax rate.
- Debt Securities – Often referred to as "baby bonds" due to their par value of $25. They pay interest like traditional bonds. Classified as 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.
Preferred securities generally offer fixed periodic payments. However, payments can be interrupted under certain scenarios that are discussed in Features, Considerations and Risks.
Most issues are offered in $25 par value denominations, although some are offered with $1,000 par value or other values.
Preferred Securities at a Glance
| Traditional Preferred | Debt Security | |
|---|---|---|
| Priority of claim | Junior to all debt, senior to traditional preferred and common equity | Senior to trust and traditional preferreds and common equity |
| Income | Dividend – declared by the board of directors |
Interest income |
| Cumulative or non-cumulative | Some may allow deferral of income | |
| Paid out of after-tax earnings | Paid out of after-tax earnings | |
| Term | Perpetual | Usually 30 years or longer |
| Usually five years non-call from issue date | Usually five years non-call from issue date | |
| Special calls may exist | Special calls may exist |
Features, Considerations and Risks
- Returns – Preferred security pricing includes 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. Preferred securities trading at a premium are more likely to be called.
- 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. Select preferreds or capital trust structures may allow the issuer to 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. Preferred payments (dividend/interest) 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 in arrears. 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 – Preferred securities can carry maturities of 20 or more years from the original issue date or have perpetual maturities. 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.
- 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.
Preferred securities combine risks of both bonds and stocks. Preferred securities are interest-rate sensitive and market conditions will affect their price. Dividends are not guaranteed and must be authorized by the company’s board of directors.
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. Preferred securities 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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