Preferred Securities: The Overlooked Fixed Income Alternative Explore why the market has quadrupled since 2005. One reason: historically attractive yields of about 5%. Another: the income may qualify for a tax-advantaged rate. Preferred securities play a unique role in investment portfolios while occupying a special place in corporate capital structures. These hybrids feature characteristics of both stocks and bonds, making them an attractive complement to “pure” equity and debt securities. Now may be a good time to consider this often-overlooked asset class and explore whether an allocation might be appropriate in the context of an investor’s risk and return objectives. Preferreds are a relative niche investment class, but their growing popularity reflects their appeal to investors seeking a level of potential risk and reward between equity and debt securities, while providing issuers with an additional source of capital. Like stocks, preferred securities issued to retail investors trade on major exchanges. They have the potential to rise or fall in value but generally exhibit less volatility than the issuer’s common shares. And, preferred shareholders have a prior claim over common stockholders to the corporation’s assets in the event of a liquidation. Like bonds, preferreds provide investors with current income through recurring payments, which may be fixed or floating. Preferred shareholders stand in line ahead of common shareholders for dividend payouts, whose yield is generally higher than the dividend yield on the issuer’s common stock. In this white paper, preferred securities are described and compared to other income-producing securities on the basis of yield and quality; their correlations to other EXHIBIT 1: PREFERRED SECURITIES major asset classes; the PRODUCT GROWTH characteristics that make 90 them exhibit less interest 80 rate risk; and their potential Total Assets (MFs, EFTs & CEFs) tax advantages. The issuer 70 landscape by industry group 60 and investor segment is 50 also reviewed. Finally, key 40 attributes that may render Billions one preferred issue more 30 suitable for an investment 20 portfolio than another are 10 defined, making the case for active management among 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 these securities. Source: Allianz Global Investors US LLC A Brief History Preferred securities were first introduced in the 19th century to help finance the completion of the railroads and canals. New investors in those projects demanded a priority dividend payment over the existing common shareholders given the significant additional capital financing required to complete the projects and the improbable distribution of common dividends over the near term. The term “preferred” refers to the holders’ payment priority over common stock. Investors ceded their voting rights and the potential for future capital appreciation normally associated with equity in exchange for a preferred income stream and a priority claim on assets, relative to existing shareholders, in the event of company’s liquidation. Collectively, the market for preferred securities is roughly $1 trillion, a four-fold increase since 20051 but somewhat smaller than the high yield market ($1.6 trillion), both of which are a fraction of the size of the U.S. equity market. 1 S&P Dow Jones Frequently Overlooked EXHIBIT 2: ISSUER VS. ISSUE (%) Despite market growth, an allocation to preferred securities is often missing from investor portfolios. Issue 93.3 Issuer The hybrid nature of a preferred may make it difficult to fit this investment class neatly in either the debt or equity universe. For investors, preferred securities have acted more like bonds. 50.0 Preferreds have a fixed par amount, make scheduled payments at either a fixed or floating 37.3 rate, and often carry a rating from a credit rating agency. 10.4 6.2 In the United States, the preferred market 0.0 became synonymous with the $25 exchange- AA A BBB listed market, which is dominated by retail Source: ICE BofAML Fixed Rated Preferred as of 6/30/2021, Bloomberg, investors given the small par size. However, the Allianz Global Investors US LLC $25 market is only part of the market available to issuers. A $1000 over-the-counter market also EXHIBIT 3: YIELD-TO-MATURITY COMPARISON exists, where institutions trade large lots, similar to the bond market. Current YTM (%) 4.60 Like bonds, preferred securities have a fixed par amount, pay scheduled payments either at a fixed 4.09 or floating rate, and rating agencies often put ratings on them. However, like equity, preferreds have very long terms, often perpetual. They have low payment priority, and may even skip or omit payments to investors. However, this is rare, and 2.11 occurs only if a company is in financial distress. All payments to preferreds must be made before 1.44 any payments to common equity holders. However, 1.00 similar to canceling a common dividend payment, omitting a payment to preferreds would not stop interest payments for bond holders or trigger a 10-Year Municipal Corporate Preferreds High Yield default for them. Given this deferral risk, the Treasury Bonds Bonds Bonds market is largely focused on investment grade Source: Allianz Global Investors US LLC, Bloomberg, ICE BofA Merrill Lynch. Yield to maturity companies, where cash flow is more stable and as of 6/30/2021 of ICE BofAML Fixed Rate Preferred Securities Index, ICE BofAML Current probability of default is lower. 10YR Index. ICE BofAML 3-7 Year US Municipal Securities Index, ICE BofAML US Corporate Index, ICE BofAML US High Yield Master Index. 2 Deep subordination and the ability to defer or forego dividend payments are features that generally drive security credit ratings to be three to five notches lower than the issuer’s senior debt. However, on a historical basis, income for preferred shareholders has generally been higher than both the dividend offered on the issuer’s common shares and the coupon payment on its bonds. The yield advantage on a preferred security over the senior debt for the same issuer can be competitive with yields of high yield bonds, often making the preferred class the highest yielding security for an investment grade company – and one of the highest yields within the fixed income markets. The preferred securities market is largely focused on investment grade companies, where cash flow is more stable, and probability of default is lower. Given issuers are generally higher-quality companies, preferreds offer the potential for income similar to high yield but with a lower probability of default. (Exhibits 2 and 3, found on previous page) Historically, preferred securities have been moderately correlated with common equities and high yield bonds. Importantly, preferreds have not been particularly correlated with 10-year Treasuries, which suggests limited links between their returns and interest rates. (Exhibit 4) EXHIBIT 4: INCREASED DIVERSIFICATION High Yield S&P 500® Levered 10-Year Preferreds Bonds Index Loans Treasury Municipals Corporates Preferreds 1.00 High Yield Bonds 0.71 1.00 S&P 500® Index 0.59 0.76 1.00 Levered Loans 0.58 0.84 0.63 1.00 10-Year Treasury 0.09 -0.22 -0.40 -0.35 1.00 Corporates 0.71 0.67 0.38 0.56 0.44 1.00 Municipals 0.44 0.35 0.06 0.27 0.54 0.65 1.00 Source: Allianz Global Investors US LLC, ICE BofA Merrill Lynch. Correlation of returns 6/30/2011-6/30/2021 of ICE BofAML Fixed Rate Preferred Securities Index, ICE BofAML US High Yield Master Index, S&P 500® Index, ICE BofAML Current 10YR Index, JP Morgan Leveraged Loans Index, ICE BofAML Current 10-Year Index, ICE BofAML 3-7 US Municipal Securities Index, ICE BofAML US Corporate Index. However, most preferred securities are issued with fixed- to-floating coupon structures. The payment structure of variable preferreds reduces their sensitivity to rising rates during the fixed rate coupon period. A security may be issued with fixed coupons for a preset number of years, commonly five or 10 years in the institutional $1000 market, and then convert to a floating rate coupon. The moving rate is set with a spread to a certain benchmark interest rate index for the remaining life of the security or until it is called. (Exhibit 5) With interest rates moving higher, investors may be EXHIBIT 5: PAYMENT STRUCTURE HELPS concerned about the potential impact on the price and LIMIT INTEREST RATE RISK yield of preferreds. However, various features of these Amount outstanding % securities can help moderate their sensitivity to changes Coupon type ($bn) outstanding in interest rates. Variable 555 70.4% Preferred securities are typically very long dated or Fixed 194 24.6% perpetual. When issued, they can have fixed coupons, Floating 19 2.4% prevalent in the retail $25 market. Similar to high yield, Other 10 1.3% the higher average coupon rate of preferreds can help Total 788 100.0% offset the negative price impact of rising interest rates. Source: Allianz Global Investors US LLC Potential for Tax-Advantaged Income Many preferred securities make payments in the form of dividends, which are taxed at a lower rate for corporations and U.S. individuals, driving comparable after-tax income higher. A key feature in the structures of preferred shares is the dividends received deduction (DRD) nature of the coupon. Dividends received by C-corporations from related entities may be tax deductible. 3 This savings is passed through to individuals who own EXHIBIT 6: PREFERREDS MAY PROVIDE preferred securities outright and to those who own them BETTER AFTER-TAX RETURNS through a mutual fund. Individuals receive the qualified Preferred security High yield security dividend tax rate on the dividend income rather than be taxed at their margin tax rate, which can translate into Par $10,000 $10,000 significant tax savings for retail investors with higher Coupon/yield 5.00% 5.00% marginal tax rates.