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. Annual payment $600 $600 Coupon tax rate 37.0% In the example to the right (Exhibit 6), a preferred security Qualified dividend tax rate 20.0% and a high yield bond start with the same 5.0% pre-tax Net of tax cash flow $480 $378 income stream. Given the differential in tax treatment, the After-tax yield 4.80% 3.78% after-tax return for the preferred security ends up higher. Source: IRS, 2019 EXHIBIT 7: PREFERREDS AND THE CAPITAL STRUCTURE Ratings examples (Moodys/S&P) Priority Capital Possible equity Payment Typical JPMorgan Bank Chase of claims structure treatment format term & Company of America Highest Senior debt No Non-deferrable Short-long term A3/A- A3/A- interest Subordinated No Non-deferrable Medium to long Baa1/BBB+ Baa2/BBB+ debt interest term Junior Limited Deferrable Long term Baa2/BBB- Baa3/BBB- subordinated debt interest Preferred equity Yes Dividend Perpetual Baa3/BBB- Baa1/BBB- securities Lowest Common equity Yes Dividend Perpetual N/A N/A Source: Allianz Global Investors US LLC

Preferreds in Issuer Capital Structure EXHIBIT 8: INDUSTRY BREAKDOWN OF THE MARKET Preferreds are a form of equity for issuers. These securities offer an ability to meet capitalization targets, particularly 1.48% 2.88% requirements established by regulators or ratings agencies, without diluting existing shareholders’ control and claim 4.25% on future earnings. 7.88% Regulated entities, such as banks, insurance companies, and utilities, represent 75% of the market. This reflects 60.65% the regulatory requirement for junior capital securities.

Unregulated corporations often issue interest bearing junior 9.79% subordinated securities classified as debt on their balance sheet but with hybrid equity features similar to preferred equity as they attempt to make an issuer more appealing in the eyes of debt rating agencies rather than regulators. 13.07%

Aside from paying interest rather than dividends, these Banks Insurance Electric Diversified Financial Services securities may offer other features of the preferred share REITS Other Telecommunications class, such as deferrable coupons and long maturities. Source: Allianz Global Investors US LLC As represented by the ICE BofA Fixed Rate Preferred Securities Index. Market Segmentation A company can issue securities into either the retail or institutional market. It generally utilizes both to diversify its investor base and tap into the various sources of capital and liquidity available to it. Retail investors are often looking at absolute coupon or yield to call, while institutional investors are usually looking at preferred securities’ comparable spread over senior bonds from the same issuer or over Treasuries.

4 While each market segment has security structures tailored EXHIBIT 9: PRICE COMPARISON OF RETAIL to its primary investor bases, a few securities exist that AND INSTITUTIONAL PREFERRED SECURITIES offer nearly identical credit and structural risk. Differences in technicals and value assessment driven by supply Issue type Retail* Institutional and demand in the two markets can cause substantial Par $25 $1000 differences in the value of similar securities over time. Coupon 5.85% 5.90% Pricing discrepancies can provide active managers with Payments Noncumulative Noncumulative the ability to move between the markets and capture value Call Date Sep-23 Jun-24 while selecting securities that seek to offer the best risk/ return profile for an investment portfolio. Maturity Perpetual Perpetual Rating Baa2/BB+ Baa2/BB+ Exhibit 9, to the right, shows how two similar preferred 12/31/2019 Retail Institutional securities issued in different segments of the market can diverge in price over time. Price 109.6 108.9 Yield-to-Call 3.28 3.74

The Case for Active Management 3/31/2020 Retail Institutional A variety of security structures within the market allow Price 97.4 98.3 managers to customize their holdings to create a portfolio Yield-to-Call 6.82 6.49 with the risk/reward features that suit their strategies. 2/26/2021 Retail Institutional Price 103.6 106.2 n Character/issuer treatment – A preferred issue may be characterized as either equity or debt on an issuer’s Yield-to-Call 4.22 3.92 balance sheet. 6/30/2021 Retail Institutional n Priority of claims – Preferred securities are junior to Price 110.2 107.8 the company’s debt and are senior only to common Yield-to-Call 1.29 3.17 equity. If a company filed for bankruptcy and assets Source: Bloomberg, Allianz Global Investors US LLC were liquidated, the proceeds would go first to pay off * The price of the retail security has been adjusted to offer a comparison with the creditors. The most senior creditors would get paid first, institutional security. and then any remaining proceeds would flow down the waterfall of the capital structure. Recovery rates, the amount received in liquidation as a percentage of par, would be lower the further down the capital the securities are positioned. n Nature of payment – Distributions of preferred securities could be in the form of interest or dividend payments and paid on either a quarterly or semi-annual basis. The tax characteristics of the payment depends on the jurisdiction of the issuer and investor and may also depend on the specific security structure. Interest payments are tax deductible for the issuer, but usually fully taxable for the investor. Dividend payments are not tax deductible for the issuer, but they may receive beneficial tax rates for the investor. n Term – A preferred issue may be short- or long-dated, fixed maturity or perpetual. n Payment deferment option – Most preferred securities have a payment deferral feature; suspending or deferring distributions on preferreds will not trigger a default for creditors. n Cumulative or noncumulative – Individual security structures will stipulate if any missed payments are cumulative or noncumulative. Missed cumulative payments would need to be paid before dividends could be paid to common shareholders. Noncumulative payments would not be required to be repaid, but preferred distributions would need to be resumed before common dividends could be paid. n Callable – Most preferred securities are callable or redeemable prior to maturity by the issuer. This provides an issuer the right to buy the security back at par from investors before the maturity date. An issuer would likely exercise this right if interest rates declined, or if its credit spread had tightened dramatically, suggesting it could re-issue securities with lower coupons. This feature creates reinvestment risk for the investor.

5 EXHIBIT 10: COMPARING RETAIL and INSTITUTIONAL PREFERREDS

Senior or Subordinated Trust Traditional Contingent Notes: Baby Preferred Preferred Capital REIT Common Feature Bonds (TRUPs) Hybrid Stock (CoCo) Preferreds Equity Character/issuer Debt Debt Debt Equity Debt Equity Equity treatment Senior to Senior to hybrids, Junior to all TRUPs, preferreds, debt; senior Junior to all Junior to all Junior to all Junior to hybrids, and common to common debt; senior debt; senior debt; senior Priority of claims all debt and preferreds, equity; junior equity and to common to common to common preferreds and common to senior and preferred equity equity equity equity subordinate stock debt Nature of Interest Interest Interest Dividend Interest Dividend Dividend payment Paid out of pre-tax/after-tax Pre-tax Pre-tax Pre-tax After-tax Pre-tax After-tax After-tax earnings claims U.S. tax Some Mostly Fully taxable Fully taxable Fully taxable Fully taxable DRD/QDI treatment DRD/QDI* DRD/QDI Typically 30 Typically 60+ Dated Fixed Typically Term yrs original yrs original Perpetual Perpetual Perpetual Maturity perpetual maturity maturity Payment Yes, typically None Yes Yes Yes Yes Yes deferral option 5-10 yrs Cumulative or Cumulative + Cumulative + Cumulative Cumulative Noncumulative Cumulative Noncumulative noncumulative Noncumulative Noncumulative Typically after Typically after Typically after Typically after Typically after Callable Yes, various No 5 yrs 10 yrs 5 or 10 yrs 5 or 10 yrs 5 yrs Source: Allianz Global Investors US LLC *DRD—dividend received deduction. QDI—Qualified dividend income.

The Takeaway: Like Golf, Hybrids Offer Versatility

In golf, hybrid clubs can combine the best qualities of fairway woods and long irons and (if swung right) avoid the negatives of both. In investing, preferreds can be considered an income hybrid with the potential to help investors diversify their fixed income portfolios, achieve an attractive return, and manage interest rate risk in a To learn more rising rate environment—all in all, a good tool to have in a strategic about the potential asset allocation. advantages of preferreds, please contact us at 800-243-4361 or visit virtus.com

6 INDEX DEFINITIONS ICE BofA Fixed Rate Preferred Securities Index (Credit quality: BBB) tracks the performance of fixed-rate U.S. dollar-denominated preferred securities issued in the U.S. domestic market. ICE BofA Current 10 YR Index is a subset of the Bank of America Treasury Master Index. The index measures the total return performance of U.S. Treasury bonds with an outstanding par that is greater than or equal to $25 million. ICE BofAML 3-7 Year US Municipal Securities Index is a market capitalization-weighted index of investment grade tax-exempt municipal bonds with maturities of 3-7 years. The index is calculated on a total return basis. The ICE BofAML U.S. Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market. The ICE BofA US High Yield Index tracks the performance of below investment grade U.S. dollar denominated corporate bonds publicly issued in the U.S. domestic market and includes issues with a credit rating of BBB or below. The S&P 500® Index is a free-float market-capitalization weighted index of 500 of the largest U.S. companies. The index is calculated on a total return basis with dividends reinvested. The J.P. Morgan Leveraged Loan Index is designed to mirror the investable universe of U.S. dollar institutional leveraged loans, including U.S. and international borrowers. The indexes are unmanaged, their returns do not reflect any fees, expenses, or sales charges, and are not available for direct investment. GLOSSARY Yield to Maturity is the yield to maturity is the percentage of the rate of return for a fixed-rate security should an investor hold onto the asset until maturity. Correlation Coefficient is a measure that determines the degree to which two variables’ movements are associated. The correlation coefficient will vary from -1 to +1. A -1 indicates perfect negative correlation and +1 indicates perfect positive correlation. Qualified Dividend Income: A qualified dividend is a dividend that falls under capital gains tax rates that are lower than the income tax rates on unqualified, or ordinary, dividends. IMPORTANT RISK CONSIDERATIONS Contingent Convertible Securities: Contingent convertible securities (“CoCos”) are subject to greater levels of credit and liquidity risk than fixed income securities generally. They may rank junior to other creditors in the event of a liquidation or other bankruptcy-related event and become further subordinated as a result of conversion from debt to equity. Issuer Risk: The portfolio will be affected by factors specific to the issuers of securities and other instruments in which the portfolio invests, including actual or perceived changes in the financial condition or business prospects of such issuers.Equity Securities: The market price of equity securities may be adversely affected by financial market, industry, or issuer-specific events. Focus on a particular style or on small or medium-sized companies may enhance that risk. Preferred Stocks: Preferred stocks may decline in price, fail to pay dividends, or be illiquid. Debt Instruments: Debt instruments are subject to greater levels of credit and liquidity risk, may be speculative and may decline in value due to changes in interest rates or an issuer’s or counterparty’s deterioration or default. Convertible Securities: A convertible security may be called for redemption at a time and price unfavorable to the portfolio. High Yield Fixed Income Securities: There is a greater risk of issuer default, less liquidity, and increased price volatility related to high yield securities than investment grade securities. Liquidity: Certain securities may be difficult to sell at a time and price beneficial to the portfolio.ABS/MBS: Changes in interest rates can cause both extension and prepayment risks for asset- and mortgage-backed securities. These securities are also subject to risks associated with the non-repayment of underlying collateral, including losses to the portfolio. Foreign Investing: Investing in foreign securities subjects the portfolio to additional risks such as increased volatility, currency fluctuations, less liquidity, and political, regulatory, economic, and market risk. Variable Distribution Risk: Periodic distributions by investments of variable or floating interest rates vary with fluctuations in market interest rates. RATINGS DISTRIBUTION METHODOLOGY Credit ratings issued by Nationally Recognized Statistical Rating Organizations assess the credit worthiness of the issuers of the underlying securities and not to the Fund or its shares. Ratings are measured using a scale that ranges from AAA (highest) to NR (not rated). Not rated securities do not necessarily indicate low quality. The security’s credit rating does not eliminate risk and credit ratings are subject to change. Credit Quality reflects the middle rating of Standard & Poor’s (S&P), Fitch and Moody’s. If there are only two ratings available, the lower rating of the two will be used. Only one rating will be utilized if only one is available. Ratings are then adjusted to the S&P rating tiers shown.

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