Preferreds: An Unfamiliar Corner of the Market

What Are Preferred Securities?

Preferred securities are a hybrid asset class, combining elements of both stocks and bonds. They provide income like bonds but represent ownership in a company like stocks. Preferreds rank higher in the capital structure than common equity, though they remain subordinate to debt holders. This gives preferred investors a higher claim on assets than common equity in the event of liquidation, placing them in a unique position within a company’s hierarchy. As a result, preferreds allow investors to capitalize on both bond-like income and equity-like growth, making them a unique investment opportunity.

Income Potential and Tax Efficiency

The primary appeal of preferreds is their income generation. They typically offer higher yields than bonds, with dividends paid regularly—often quarterly. These dividends may be eligible for Qualified Dividend Income (QDI) tax treatment, a significant tax advantage for investors. Under current tax laws, QDI is taxed at preferential long-term capital gains rates (typically 0%, 15%, or 20%), rather than at ordinary income tax rates, which can be as high as 37% for some taxpayers.

For dividends to qualify for QDI treatment, the issuing company must meet certain criteria, and the investor must meet holding period requirements. For investors in higher tax brackets, the tax efficiency of preferred securities can significantly boost after-tax returns. QDI treatment allows investors to retain more of their dividend income compared to other fixed-income investments, such as corporate bonds, where interest income is taxed at ordinary income rates. This makes preferreds an attractive option for income-focused investors looking to maximize their after-tax yield and minimize their tax burden.

Diversification

Preferred securities offer portfolio diversification with a risk/return profile that is less correlated to traditional fixed-income assets like bonds and more tied to a company’s creditworthiness than its stock price. This allows preferreds to offer a unique blend of income, with a risk profile that behaves differently from bonds and common stocks.

Unlike bonds, which offer steady income with lower sensitivity to a company’s performance, preferreds are more responsive to a company’s financial health and equity market conditions, offering investors a mix of stability and growth potential. While preferreds provide greater structural protection due to their higher claim on company assets, their drawdown risk can resemble that of equity markets, particularly during significant market downturns.

By combining the characteristics of both stocks and bonds, preferreds serve as a valuable diversifier, helping to reduce overall risk while providing tax-advantaged income. This hybrid nature makes preferreds an appealing option, allowing investors to diversify both their income sources and risk exposure, reducing reliance on fixed income or equities alone.

Why Consider Preferreds in Your Portfolio?

• Differentiated Income: Distinct income source with higher yields than traditional bonds.
• Diversification: Unique risk/return profile, less correlated to both stocks and bonds.
• Tax Efficiency: Potential for lower taxes on dividends through Qualified Dividend Income.
• Credit Exposure: Exposure to a company’s creditworthiness, not just its stock attributes.
• Capital Structure: Higher claim on assets than common equity in times of distress.

Our Approach

We recognize the value of preferred securities in building a diversified, income-generating portfolio. We generally gain exposure to this asset class through actively managed strategies, where managers have the resources to thoroughly analyze the markets and relevant documentation specific to each investment. We may also purchase individual securities that align with our clients’ income, return, and risk objectives, provided we have a strong understanding of and confidence in the issuing entity. Our use of preferreds is designed to leverage all their key attributes.