Preferred securities are beginning to look more attractive for long-term investors.
The rise in long-term Treasury yields so far this year has pulled down prices of preferred securities. While that has led to disappointing total returns in 2018, it has presented investors a more attractive entry point to earn higher yields. But preferred securities come with a unique set of characteristics, including greater risks, so it’s important to understand all of the nuances before investing.
What are preferred securities?
Preferred securities are a type of hybrid investment that shares characteristics of both stocks and bonds.
Like bonds, preferred securities have fixed par values and make scheduled coupon payments throughout the year. Preferreds often pay quarterly, however, while traditional bonds usually make semiannual payments. Preferred securities are often rated by credit rating agencies such as Standard and Poor’s or Moody’s Investors Service.
Like stocks, however, preferreds rank very low on an issuer’s priority of payments, and the coupon payments are often discretionary, meaning they can be suspended without triggering a default, unlike a missed payment on a traditional bond. Preferred securities rank above an issuer’s common stock. In order for a corporation to pay a common stock dividend, it first needs to make its payment to its preferred shareholders—hence the name “preferred.”
Why are they attractive now?
The year-to-date rise in long-term Treasury yields has lifted the yields offered on many preferred securities. Preferred securities have very long maturity dates, or in many cases no maturity date at all, making them very sensitive to fluctuations in long-term bond yields. The 10-year Treasury yield has risen almost 70 basis points this year (one basis point is equal to one hundredth of one percent, or 0.01%).1
Preferred securities share many characteristics with traditional bonds, and their prices and yields move in opposite directions. The rise in yields has pulled preferred securities’ prices lower. Lately there has been a strong inverse relationship between 10-year Treasury yields and preferred securities prices.
Preferred securities’ prices historically have had a strong relationship with 10-year Treasury yields
Source: Bloomberg, using monthly data as of 11/15/2018. ICE BofA ML Fixed Rate Preferred Securities Index and US Generic Govt 10-Year Yield (USGG10YR Index). Past performance is no guarantee of future results.
Preferred securities’ prices have fallen sharply this year. At the time of this writing, the average price of the ICE BofAML Fixed Rate Preferred Securities Index had dropped to $97.2, down 7.3% from 2017’s close of $104.8. Given the steep price decline this year, the index has posted a year-to-date total return of negative 2.8%, as the high coupon income hasn’t been enough to completely offset the price declines.2
Lower prices have historically led to higher returns down the road, however. The drop in preferred securities’ prices has presented investors a more attractive entry point, as long as they have a long investing horizon and can stomach heightened volatility.
The chart below breaks down the average 12-month total return of the aforementioned preferred securities index, broken down by various average starting price cohorts. When the average price of the index dips below $100, forward returns have generally been strong.
Average total returns have been strong when the starting price is below $100
Source: Schwab Center for Financial Research and Bloomberg. Forward 12-month total returns of the BofA Merrill Lynch Fixed Rate Preferred Securities Index using monthly data from 4/30/1989 through 10/31/2018. Past performance is no guarantee of future results.
Preferred securities should be considered long-term investments
Preferred securities have very long maturities, or in many cases no maturity date at all, so they should always be considered long-term investments. Their long maturities also mean that they have elevated interest rate risk (that is, the risk that the price of an investment will change as a result of a change in interest rates). When long-term bond yields are rising, as they have been this year, prices can drop sharply lower, leading to poor total returns. Through November 15th, 2018, the year-to-date total return of the index was negative 2.8%.
However, the high coupon rates that preferred securities pay can help, over time, to offset some of the price swings that go along with interest rate fluctuations. The average coupon rate of the ICE BofAML Fixed Rate Preferred Securities Index is 5.7%.
Looking at rolling 24-month total returns, the only times the index posted negative returns were in the years leading up to, and then during, the 2008 financial crisis. And while the most recent reading in the chart below may appear low, that has more to do with the scale of the chart than the strength of the return. In the 24-month period ending October 31, 2018, the cumulative total return of the index was 5.3%, besting both the Bloomberg Barclays U.S. Aggregate Bond Index total return of negative 1.2% and the Bloomberg Barclays U.S. Corporate Bond Index total return of 0.4%.
Over long investing horizons, preferred securities have generally delivered positive total returns
Source: Schwab Center for Financial Research with data from Bloomberg. Rolling 24-month total returns of the ICE BofAML Fixed Rate Preferred Securities Index from January 1992 through October 2018. Total returns assume reinvestment of income payments and capital gains. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.
Rising long-term yields pose a risk, but we think the worst is behind us
Preferred securities have elevated interest rate risk because of their long maturities (or no maturity dates at all). When all else is equal, securities with longer maturities are more sensitive to rising interest rates than an investment with a shorter maturity.
Despite our outlook for the Federal Reserve to continue to gradually raise interest rates, we don’t expect long-term yields to rise much further. Given that outlook, preferred securities prices might not fall much further.
Historically, 10-year Treasury yields tend to peak right near the peak federal funds rate of a given cycle, as shown in the chart below. With the exception of the early 1990’s rate hike cycle, during which the Fed hiked rates really quickly, 10-year Treasury yields typically don’t get much higher than the Fed’s “terminal” rate. The most recent Federal Open Market Committee (FOMC) projections point to a federal funds rate of roughly 3.4% in 2020 and 2021. With 10-year Treasury yields currently around 3.1%, we think the upside in long-term yields is limited.
10-year Treasury yields historically tend to peak near the peak federal funds rate of a given cycle
Source: Bloomberg. US Generic Govt 10 Year Yield (USGG10YR Index) and Federal Funds Target Rate Mid Point of Range (FDTRMID Index). Monthly data as of 10/31/2018.
There are risks to long-term yields rising in the near term, such as the reduction of the Federal Reserve’s Treasury holdings or a rise in Treasury issuance due to growing deficits. If those were to lead to higher long-term yields, preferred securities’ prices could fall even lower.
How to invest?
The preferred stock and securities market is a niche market. Investing in preferreds can be a daunting task, given the various types of preferreds, each with their own individual characteristics.
Investing through an active manager has many benefits compared to investing in preferred-security-focused exchange-traded funds (ETFs) that merely track an index. Working with a manager can mean investing in actively managed mutual funds or separately managed accounts that invest in preferreds. But there’s also an added cost involved: active managers tend to charge higher fees than a passive, index-tracking approach. But with so many nuances with the preferred securities market, an active manager can evaluate each issue individually and make an informed decision about what to own and not to own.
What to do now?
Preferred securities’ yields have risen recently, making it more attractive to invest today, but make sure you have a long-term investing horizon so you can ride out periodic bouts of volatility. And due to their more aggressive risk profile, we always think preferred securities make sense as a complement to core fixed income holdings, not as a substitute.
If you are looking for higher income and have a long investing horizon, a Schwab fixed income specialist can help you navigate this market and figure out what approach makes the most sense for you.
1 Yield as of November 16, 2018.
2Total return from December 31, 2017 through November 15, 2018.
What You Can Do Next
- Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
- Explore Schwab’s views on additional fixed income topics in Bond Insights.