Opportunities in Preferred Securities

Taxable Portfolio Manager Stephen Repoff shares his perspective on the perpetual preferred market, including his latest thoughts on the outlook for the sector, the role preferreds can play in a diversified portfolio, and how GW&K approaches this unique segment of the fixed income market. He also explains some advantages of preferred securities he believes investors should consider.

Q: First off, can you provide some background on perpetual preferreds?

Stephen Repoff: Perpetual preferreds are securities that are effectively a hybrid of bonds and stocks. They make regular cash payments and trade on a par basis like traditional fixed income instruments, and they have no final maturity and can remain outstanding indefinitely like stocks. They also tend to be issued by companies that are tightly regulated, well capitalized, and in traditionally stable industries, like banking, insurance, and utilities.

Preferreds pay coupons that are either “fixed-for-life” or fixed for a given period of time (typically five years) before they begin resetting periodically thereafter; these are called “fixed-to-float” or “fixed-to-fixed,” depending on the frequency of their reset cadence. These different features create a variety of unique risk-factor exposures and return profiles. Preferreds are also redeemable by the issuer at par after several years.

Q: You mention regular cash payments – can you speak to preferreds’ expected returns?

Stephen: Preferred yields tend to be several percentage points higher than Treasury rates, offering a “spread” to compensate for credit risk. Preferred issuers tend to be highly rated (i.e., the companies themselves are investment grade), but because the preferreds are subordinate to senior debt, their ratings are notched lower and their spreads are commensurately higher.

Additionally, the perpetual nature of preferreds tends to result in more volatile price movements, so investors typically demand a greater risk premium for this uncertainty. Depending on the market environment and investor tolerance for credit risk and volatility, preferreds can trade at a meaningful discount to par and thereby offer potential for price appreciation.

Q: Why should investors consider investing in preferreds today?

Stephen: The primary advantage preferreds offer is their yield, particularly in light of the high credit quality of the largest issuers in the space. As of December 31, 2023, the yield to worst* of the ICE BofA Fixed Rate Preferred Index was 6.33%, with the fixed-to-float component carrying a YTW of 6.91%. This is a spread of 227 basis points above Treasuries for investment-grade securities. This high credit quality reduces the risk of default and limits volatility in an uncertain macroeconomic environment.

Variable-rate preferreds are particularly compelling during periods of heightened interest rate uncertainty. Typically, bond prices decline when interest rates rise, but preferreds are less sensitive to this factor because their rates reset every few years. As part of a broader portfolio, preferreds offer an appealing alternative to equities and high yield debt.

Q: What does GW&K’s active management style offer in the space?

Stephen: Looking at fundamentals, our bottom-up research process informs our decision to hold each preferred in the portfolio. We analyze credit metrics, governance, asset quality, and revenue diversification. This process has driven our decision to maintain an up-in-quality bias among financials and avoid banks with less robust balance sheets, in keeping with our aim of limiting volatility and preserving principal.

We perform scenario analyses and stress tests on each of our holdings to identify risks and opportunities, which offer advantages from a valuation perspective. The results of these exercises inform our assessment of yields and the broader construction of the portfolio to optimize for risk-adjusted returns across a variety of potential outcomes.

From a technical standpoint, there are many factors that drive price movements in preferreds beyond interest rates and credit spreads. New issuance trends, rate volatility, and the likelihood of redemption can all have a meaningful influence on risk/return profiles. These complexities create an opportunity for active managers like GW&K, since we closely monitor them and actively seek to exploit dislocations that result.

Q: What else do you think investors should know about investing in preferreds?

Stephen: The majority of the preferred market, and 100% of the holdings in our Strategy, pay dividends that are treated as qualified dividend income (QDI). This means that payments are taxed at the lower long-term capital gains rate of 20%, rather than at the ordinary-income rate like traditional bonds. This means a preferred with a 6.3% yield offers a taxable equivalent yield of approximately 8.1% (Figure 1).

Figure 1 - Preferreds Can Offer Investors Tax Benefits


*Yield to worst (YTW) is the yield calculated to the effective maturity data. It is the lowest possible yield an investor can expect, absent a default, expressed as an annual rate.

Published February 2024


This represents the views and opinions of GW&K Investment Management. It does not constitute investment advice or an offer or solicitation to purchase or sell any security and is subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes.

Investing in securities or investment strategies, including GW&K’s Investment Strategies presented in this document, involves risk of loss that clients should be prepared to bear. No investment process is free of risk; no strategy or risk management technique can guarantee returns or eliminate risk in any market environment. There is no guarantee that GW&K’s investment processes will be profitable, and you therefore may lose money. Past performance is no guarantee of future results. The value of investments, as well as any investment income, is not guaranteed and can fluctuate based on market conditions. Diversification does not assure a profit or protect against loss. GW&K’s active management styles include equity and fixed income strategies that are subject to various risks, including those described in GW&K’s Form ADV Part 2A may be found at the SEC’s website under Firm 121942, or is available from GW&K upon request.

Indexes are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. Index data has been obtained from third-party data providers that GW&K believes to be reliable, but GW&K does not guarantee its accuracy, completeness or timeliness. Third-party data providers make no warranties or representations relating to the accuracy, completeness or timeliness of the data they provide and are not liable for any damages relating to this data. The third-party data may not be further redistributed or used without the relevant third-party’s consent. Sources for index data include: Bloomberg, FactSet, ICE, FTSE Russell, MSCI and Standard & Poor’s.


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