For the past several years many investors have been hearing about the attractiveness of preferred stocks, since they typically offer much higher yields than investment grade bonds and less risk than many high-yield bonds. Preferred yields generally range from 4-8%, or even higher, and issues are available from large, well-known, high quality companies which provide another degree of comfort. Preferred stock typically offers higher yields because they rank lower in priority than bonds should a negative credit event occur (bankruptcy or restructuring). Therefore, preferred stock may seem like a nice niche to generate attractive yield, while taking limited additional credit risk. But don’t be fooled into assuming that all of these high yield preferreds are attractive: looks can be deceiving.
The iShares U.S. Preferred Stock ETF (PFF) is a large, liquid preferred ETF with a market capitalization of $16 billion. The PFF currently yields about 6.2%, higher than the Barclays Aggregate Bond Index yielding nearly 3.3%, and the HYG, a high yield bond ETF, yielding 5.4%. The erosion of the value of the PFF over the last two years, however, indicates potential risks are lurking below the surface. PFF’s price is down over 5%, excluding dividends paid. Three subtle, but significant reasons–duration, coupon risk, and call risk–underlie the decline in the value of this preferred-based ETF.
Preferreds are typically perpetual, which means the issuer can choose to leave them outstanding forever. The majority of preferreds have a fixed rate coupon, and this causes preferreds to have much higher duration than the vast majority of bonds. For example, a fixed-rate perpetual with a 5% coupon has a duration of approximately 20 years, which implies that a 1% rise in interest rates, all else equal, will cause a 20% drop of a $100 preferred. While the assumption of all else equal is a simplifying assumption, that drop in price may be partially offset if there are any business benefits associated with that rise in the market interest rate.
A second vulnerability to the value of preferreds arises from coupon risk. The coupon payment on preferreds varies across each security, but most preferreds are either fixed rate for life or fixed rate for a period of time, often 5 or 10 years, before floating. The coupon risk arises when the current market rates are below the rates at which the preferred was issued. For example, if a 5% fixed coupon security becomes floating at LIBOR + 4.0%, investors would eventually benefit when it becomes floating since the coupon would increase to 6.3%. If a 5% fixed rate security becomes floating at LIBOR + 2.0%, however, the coupon would decline to 4.3%, resulting in lower cash flow. This lower cash flow could potentially affect the trading value of the preferred if similar securities still trade at a 5% yield.*
The third risk which has become more prevalent in 2018 is call risk. Call risk results from the issuer sometimes having the option to redeem perpetual preferreds. Many preferreds are callable 5 or 10 years after issuance at the discretion of the issuer, and if a company can refinance at a lower rate, it will do so. If market rates have risen or the issuer’s credit quality has deteriorated, however, the preferred will remain outstanding perpetually to the detriment of the holder since its price will fall. We have recently seen redemptions of higher-coupon preferreds, since most of those issuers have stronger balance sheets than they did 5-10 years ago in the immediate aftermath of the financial crisis. Some preferreds are particularly vulnerable since they are trading above par and are callable today. Therefore, the issuer choosing to redeem the preferreds at par will force a loss on the holder. Two multi-billion dollar HSBC preferreds—two of the top-6 holdings in the PFF—were recently redeemed at par which resulted in losses for holders of 3%-4% and likely contributed to the PFF’s decline. There are several additional preferreds with such call risk remaining in the market.
While we remain cognizant of the three subtle risks discussed above, namely duration, coupon risk, and call risk, we continue to view the preferred segment as an attractive one in which to find investment opportunities. We maintain a strong preference for individually selected securities, however, to ensure each preferred is attractive both on its own merits and as part of a broader investment portfolio.
*Note: LIBOR is the short-term rate that most commonly determines the floating rate of preferreds.