Interest rates are coming down, but investors can still find some solid opportunities for yield in the preferred securities market, according to UBS Financial Services. Preferred securities combine attributes of bonds and stocks. They trade publicly on exchanges, but they also pay a quarterly stream of income. Issuing companies are often banks and utilities. Yields for these instruments can top 5%, and this income may be tax advantaged for investors. Generally, the coupons are taxed at the same rate as qualified dividends – that is, 0%, 15% or 20%, based on an investor’s taxable income. Meanwhile, interest income from bonds is taxed as ordinary income, meaning it’s subject to rates as high as 37%. Retail investors and preferreds The preferred securities sold to retail investors come at a fixed par value of $25. The coupons can either be fixed for the whole term or can be “fixed to floating,” meaning the rate adjusts after a specified period. While many preferreds have long maturity dates or they’re perpetual, they often have “call dates,” after which the issuer can redeem them. In a falling interest rate environment, issuers may call back preferreds, leaving investors scrambling for a replacement security. This activity is more prevalent in the $1,000 par market, as those securities tend to have variable rate coupons, while the $25 par market tends to be primarily fixed rate, according to Frank Sileo, senior fixed income strategist at UBS. Similarly, an investor who buys a preferred at discount and has it called away at par may appreciate getting a gain, but now faces reinvestment risk, he added. They have may have a harder time finding assets with a comparable yield. Further, preferreds that are true perpetual securities have greater interest rate sensitivity, resulting in price volatility, Sileo said. “When rates go down, the price will appreciate and do so significantly and when rates go up, they depreciate,” he said. “People sometimes say, ‘I buy them for the income, and I don’t care about price volatility’ — until it happens,” Sileo said. “Then you have this unrealized loss on your statement, which can be uncomfortable.” Another risk to consider is that investors holding preferred stock have lower seniority than bondholders in a company’s capital structure. In the event an issuer is liquidated, preferred holders rank below bondholders but above common stockholders, who are generally wiped out. This also means investors should be aware of the issuers’ credit ratings before buying preferreds. Companies with credit ratings of BBB- or better are deemed investment grade by Standard & Poor’s. Investors who would rather buy a basket of preferreds, which can offer exposure to different companies, may want to consider an exchange traded fund. The iShares Preferred and Income Securities ETF (PFF) has an expense ratio of 0.46% and a 2024 total return, including reinvested dividends, of more than 11%. There is also the First Trust Preferred Securities and Income ETF (FPE) , which has an expense ratio of 0.84% and a total return of 12% in 2024.
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