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A Quick Overview Of Preferred Securities

By Louis P. Stanasolovich, CFP®, CCO, CEO and President of Legend Financial Advisors, Inc.®and EmergingWealth Investment Management, Inc.®


Preferred securities are somewhat of an enigma.  They have a fixed return over time (although some preferred securities have an adjustable rate payout), but can suffer a major loss if the corporation issuing them has financial difficulties.  It should be noted that “preferred” means these securities have a preferred position in the event of a liquidation of a corporation over that of common equity holders, but behind bank and bond debt holders. 

                                                                                               

The only upside, other than the coupon payout, is if a preferred security is convertible into common equity.  Complicating matters is the fact that many preferred securities have very low trading volume and approximately 80.0% of the preferred securities universe is concentrated in the finance sector. 

 

Normally, it is hard to be excited about these securities, except in a falling interest rate environment.  However, in an environment of relatively stable interest rates, preferred securities may offer competitive returns to that of other higher yielding, fixed income securities.  Purchasing individual issues, from a liquidity standpoint though, is to be avoided.  Mutual funds focusing on preferred securities, depending upon the management team, may be a suitable investment option.  Listed below are some other thoughts on this investment category.

 

Preferred securities are well positioned relative to other credit sectors.  They offer relatively high income rates and offer tax-advantaged dividend income for U.S. buyers.  Strong and improving credit fundamentals of many preferred issuers at this time, in particular, banks, provide potential for further narrowing in credit spreads.

 

Exchange-Traded preferred securities are normally more sensitive to bond-yield moves than preferred securities traded over the counter (OTC), given a prevalence of longer-duration (Durationis an approximate measure of an investment security’s price sensitivity to changes in interest rates.  The longer the duration, the more sensitive the security is.) securities, they have held up better than the OTC market.  This situation reflects tighter supply conditions.  Notably, Exchange-Traded-focused preferred securities, which are significant investors in the Exchange-Traded Fund group, have had the need to replace redeemed securities with existing issues, recycling capital into a low-supply market.

 

Over the intermediate term, Treasury yields may see some upward pressure as the U.S. economy accelerates.  As these trends unfold, high income rates offered by preferred securities may help protect investors from a total-return perspective should prices be negatively impacted by higher bond yields.  Favoring higher-income securities with wide credit spreads and lower-duration fixed-to-float (The fixed coupon becomes a floating rate one at some point.) structures with significant amounts of call protection, which have the potential to perform well in most interest-rate environments, would be prudent.

 

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REPRINTED WITH PERMISSION OF LEGEND FINANCIAL ADVISORS, INC.®




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