Preferred Securities: Recent Rally Sets High Bar

Preferred securities have been one of the best-performing fixed income investments over the past six months, aided by lower long-term Treasury yields and the general "risk-on" theme that has propelled many stock indexes to all-time highs.

Our outlook is still positive, but it may be difficult to replicate the strong returns of the past few quarters going forward. We don't necessarily expect prices to fall—they should be range-bound for the near term—but investors should focus more on the high income offered by preferreds rather than the potential for more near-term price appreciation.  

We see both benefits and risks with preferred securities today:

Benefits:

• High income
• Potential tax benefits
• Attractive entry point relative to history for long-term investors

Risks:

• Low relative yields
• Price appreciation may be limited over the short run

High income payments and yields are key benefits of preferred securities for income-oriented investors. Since preferred securities are a type of hybrid investment that shares characteristics of both stocks and bonds, they tend to offer high yields to compensate for heightened risks and additional complexities.

Yields have risen sharply over the past few years and the ICE BofA Fixed Rate Preferred Securities Index now offers an average yield-to-worst of more than 5.5%. That's off its recent high of 7.8% from last fall but is at the high end of the 10-year pre-pandemic range.

Many preferred stocks pay qualified dividends that are subject to lower tax rates than traditional interest income. Investors considering preferreds relative to other investments should always consider what type of account they'll be held in—taxable or tax-advantaged—and if held in taxable accounts, the after-tax yield. Not all preferred stocks or securities pay qualified dividends—some pay interest—so it's important to know what you own and what the tax consequences are. Qualified dividends are generally taxed at 0%, 15%, or 20% rates, depending on income limits. Those lower rates can be an advantage for investors in high tax brackets.

The entry point is relatively attractive for long-term investors with the average price of the preferred index below $94. Keep in mind that most preferreds in the index have par values of $25, but the average price of the index is rebased to $100. Prices are relatively low given the rise in long-term Treasury yields over the past few years, since prices and yields move in opposite directions.

Although prices are low relative to history, there might not be much upside potential in the short run unless the downtrend in long-term Treasury yields resumes. Because preferred securities have long maturities (or no maturities at all), changes in the 10-year Treasury yield can influence the price and yield of preferred securities.

We see fair value for the 10-year Treasury yield in the 3.5% to 4% area, compared with its current yield of roughly 4.2%. That suggests there is room for yields to move lower from here, which could boost preferred security prices. However, the Federal Reserve has recently signaled that it may not cut rates until the second half of the year and there may be fewer cuts than previously expected. Those factors could keep the 10-year Treasury yield above 4% for the next few months, potentially limiting the potential price appreciation with preferred securities.

Since early 2010—and with the exception of the spike in 2020—the six-month rolling return of the ICE BofA Fixed Rate Preferred Securities Index has rarely topped 10%. The total return of the index through the six months ending March 22, 2024 was 10.7%, suggesting that there might not be much near-term upside if the historical relationship holds.

Low relative yields are another reason to temper enthusiasm for preferred securities. The average yield-to-maturity of the ICE BofA Fixed Rate Preferred Securities Index is roughly 6.3%.¹ We believe that's attractive on the surface, but it's not much of an advantage over the 5.5% yield of the Bloomberg U.S. Corporate "BBB" Bond Index.² The average credit rating of that preferred security index is in the mid-"BBB" area, so comparing yields to BBB rated corporate bonds provides a more apples-to-apples comparison.

That 80-basis-point yield advantage that preferreds offer relative to similarly rated corporate bonds is low considering it averaged roughly 200 basis points from 2010 through 2019 (a basis point is one one-hundredth of a percentage point, or 0.01%). Given that relatively small yield advantage, in our opinion more-conservative to moderate investors should just consider investment-grade corporate bonds and the more than 5% average yields they offer rather than reaching for yield with preferreds today.

Investors that are looking for income and are willing to take some risk for higher yields could consider preferreds, but investors with more-conservative to moderate risk tolerances might want to consider investment-grade corporate bonds instead. Investment-grade corporate bonds offer average yields of 5% or more with less credit risk than preferreds.³ For those considering preferreds, we always suggest that they be considered long-term holdings given their long maturities.

There are a number of ways to invest in preferred securities. Schwab clients can use the Preferred Shares Screener when looking for individual preferreds, or can explore funds on the ETF or Mutual Fund pages; preferred funds can be found under the Morningstar category of "Preferred Stock." You can also consider a separately managed account.