Preferred securities are a type of investment that generally offers higher yields than traditional fixed income securities, such as U.S. Treasury securities or investment-grade corporate bonds. However, the higher yields come with different risks. Show
Preferred securities are sometimes considered by investors seeking higher income. They were also one of the hardest-hit investments during the 2008-2009 global financial crisis and in the early stages of the 2020 COVID-19 pandemic. What should you be aware of now to decide whether preferred securities might be the right investment for you for a more-aggressive part of your income portfolio? What are preferred securities?Preferred securities are "hybrid" investments, sharing characteristics of both stocks and bonds. In fact, there are many types of preferred securities, each with their own set of characteristics or guarantees. Lately, the term "preferred security" has been used as a blanket term for an investment with a par value of $25, but they can rank as high as a senior bond or as low as traditional preferred stock.1 Bond-like characteristics:Fixed par value
Regular income payments
Credit ratings
Maturity date
Stock-like characteristics:Low ranking
Preferreds can rank as high as traditional senior unsecured bonds and rank above common stockSource: Schwab Center for Financial Research and Standard and Poor's. Weaker obligations to pay income
Exchange-traded
There is one additional characteristic that can fall under either stocks or bonds: tax treatment. Depending on the structure of the preferred, which we discuss below, the income payments can either be taxed as qualified dividends or taxed as interest income. Preferreds tend to offer higher yields than traditional bonds due to these complex characteristics. Since they rank below traditional bonds, have very long maturities, and don't enjoy the same income payment priority as traditional bonds, investors tend to demand higher yields to compensate for those risks. Types of preferred securitiesThere are several varieties of preferred securities and the terms used to describe them can be complex. Here are the primary types, beginning with those that rank lowest in the issuer's capital structure:
Typical preferred security structuresSource: Schwab Center for Financial Research. Why do companies issue preferred securities?Companies generally issue preferred securities for flexibility. The primary issuers tend to be financial firms, such as banks or real estate companies, which need easy access to debt markets to operate. But other companies, such as utilities and industrial companies, often issue preferred securities as well. Preferred securities provide these companies with flexibility as an extra financing tool in addition to common stock and more-traditional corporate bonds. Banks, which have strict regulatory requirements, are also able to use preferred securities as a source of capital "cushion" between their bonds and common stock. Bank regulations require certain levels of capital reserves, and preferreds can help meet that objective. The degree of capital treatment varies depending on the type of preferred security. Preferreds do come with additional risksHigher yields may be appealing, but they almost always come with the additional risks described below. However, lower yields that other investments offer can also be risky—in terms of maintaining purchasing power, meeting living expenses and so on. So there are tradeoffs. Which risks are most important to you? Risk of large drawdowns
Higher yields come with greater risksSource: Bloomberg, as of January 31, 2022. Worst rolling 12-month total returns are from 12/31/99 to 1/31/22 using monthly data. Indexes used are the Bloomberg U.S. Treasuries Index (LUATTRUU Index), Bloomberg Municipal Bond Index (LMBITR Index), Bloomberg U.S. Aggregate Bond Index (LBUSTRUU Index), Bloomberg U.S. Corporate Bond Index (LUACTRUU Index), ICE BofA Fixed Rate Preferred Securities Index (P0P1 Index), and the Bloomberg U.S. Corporate High-Yield Bond Index (LF98TRUU Index). Past performance is no guarantee of future results. Fewer diversification benefits than traditional bonds
Sector concentration in banks and finance companies
Lower credit ratings than the issuer's bonds
High interest rate risk
Overall, investors with higher appetites for credit risk may consider allocating up to 20% of their overall portfolio to more aggressive income investments. Along with preferred securities, that could include high-yield bonds, bank loans, or emerging market bonds. Again, preferred securities may not be appropriate for all investors. Those who do choose them should learn about some of the risks and use them strategically as a higher-risk part of their income portfolio. Find out more about individual preferred securitiesFinding good information about preferred securities can be difficult, and there are many details to understand before investing. The best source of information will always be a security's prospectus, which you can obtain from a Schwab fixed income specialist, or from data repositories available online. Schwab clients can access our Preferred Stock Screener. Don't just screen for the highest yields—also screen based on attributes such as credit rating, and then augment it with more information about the issuing company, the security listed, specific characteristics of the preferred shares (whether they coupon payments are cumulative or non-cumulative, for example, which is often listed in the security description) as well as call dates and other details. Don't just look at the issue's current yield—if a preferred is priced above par, it's important to find out its yield-to-call. A preferred with a price above its $25 par value that has an upcoming call date may result in a negative total return if it's redeemed at that call date. A fixed income specialist can help identify that yield. If you'd like a diversified solution without too much exposure to any single preferred stock or issuer, consider preferred-stock exchange-traded funds (ETFs) or mutual funds. Clients can search for "preferred stock" funds in the "taxable bond" category using the Schwab ETF Screener or the Schwab Mutual Fund Screener. Clients can also consider a separately managed account for an allocation to preferred securities, but keep in mind that they have higher investment minimums than ETFs or mutual funds. 1 Par value, also known as face value, is the amount the issuer promises to pay the bondholder when the bond matures. 2 Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated. Which of the following securities may offer convertible features that allow the holders to exchange the securities?Which of the following securities may offer convertible features that allow the holders to exchange the securities for other issues of the company? Of the choices offered, only preferred stock and bonds could be issued as convertible.
What are the features of convertible securities?In the simplest terms, convertible securities can be bonds or preferred stocks that pay regular interest and can be converted into shares of common stock of the issuing company. These securities have an option built in at the time of issue that, if exercised, allows them to be converted into common stock.
What are convertible shares?A "convertible security" is a security—usually a bond or a preferred stock—that can be converted into a different security—typically shares of the company's common stock. In most cases, the holder of the convertible determines whether and when to convert.
How are shares of convertible preferred stock similar to convertible bonds quizlet?How are shares of convertible preferred stock similar to convertible bonds? A : Both cause a decrease in the debt-to-equity ratio upon conversion.
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