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A Preferred Source of Income

A Preferred Source of Income

April 03, 2024

A Preferred Source of Income

Regarding financial assets, stocks tend to dominate the conversation, as they boast the highest long-term returns as well as the most volatility. You don’t hear as much about bonds – you’re aware of what your income will be and when you will be paid back; it’s called fixed income for a reason.

To review, when it comes to financing an enterprise, you have the following options:

Image Source: WallStreetPrep

As seen above, there is also an even less discussed third method of financing an enterprise called “preferred stock.” Preferred stock ranks lower than debt but higher than common equity in a company’s capital structure. Interestingly, preferred stock has characteristics of both debt and equity. Preferred stocks are a unique class of financing that pay regular income and tend to have higher yields than the corresponding issuer’s debt due to their lower position. Preferred stock dividends are paid after interest on debt but before any common stock dividend. Most preferreds are considered a fixed income investment. Appreciation potential is limited, they possess no voting power, and payments are delivered depending on the terms offered for each issue.

Our Current Strategy Regarding Preferred Stocks

When the financial crisis of 2008 and resulting bank bailouts occurred, many of the United States’ largest financial institutions were effectively deemed “too big to fail” and were given stringent regulations in the form of Dodd-Frank and Basel III. These firms were given the moniker of “Systemically Important Financial Institution” (SIFI). Firms such as JPMorgan Chase & Co. and Bank of America, among others, paid common stock dividends throughout the financial crisis, thus paying all outstanding preferred stock dividends as well. These institutions also have the relative size and diversified clientele to weather isolated events such as the bank runs on Silicon Valley Bank and First Republic Bank in March of 2023. This dynamic makes preferred stocks of SIFI institutions attractive from a risk-reward perspective. As a firm, we focus on preferred stocks offered by these institutions.

As previously stated, we view preferred stock through a fixed income lens. Our objective is to receive the stated yield and retain our principal. In that spirit, a bond is a contract and any preferred stock, like a bond, has different terms depending on the issue. Some preferreds may be attractive investments and some may not be; it’s our job to parse through it all and find the well-priced offerings.

Tax Implications 

Another differential we look for in the offering documents is tax treatment of the preferred stock. The income of preferred stock is typically treated as dividend income and taxed at a lower rate than interest income, thus accruing another benefit since it’s after-tax returns we are after.

If an account is tax-deferred or tax-exempt, a preferred issue paying income classified as “interest” may still be compelling to add if the price is favorable.

Fixed to Floating Issues

Higher interest rates in the last several years have impacted fixed income investments including preferred stocks. If rates continue to rise, it’s important that we can adapt to higher rates and take advantage of higher ongoing yields to capture more income. We’ve focused on a type of preferred issue known as “fixed to floating” for this. After a certain date specified in each preferred stock’s offering documents, they will not pay a fixed dividend. Instead, they will “float” by a certain amount to a specific rate. For example, a preferred issue could float to the U.S. 3 Month Treasury by 3%. When the preferred stock resets, the new yield will be the 3 Month Treasury + 3%. If the treasury rate was 5% on that date, the preferred would yield 8% until it resets again.

This helps protect against inflation, as well. If interest rates rise due to higher inflation, the preferreds would rise in yield as they reset, mimicking the rise in treasury rates. If yields on preferreds fall to levels we don’t view as favorable, we may look for other opportunities in the marketplace.

Risks of Preferred Stocks

Obviously, there’s no free lunch in investing. With regards to these instruments, two main risks present themselves:

  1. If these firms enter financial difficulties, they may not pay the preferred dividend and the issue value would materially fall as a result. The issuer would have to cut the common stock dividend completely before a penny of preferred dividends is cut.
  2. These issues can be redeemed after they start to float if the issuer deems the interest rate to be too high. The par value of the issue will be returned, and we would need to seek out a new source of income. Because of the potential to be called, we seek to buy preferred stocks at a discount to par value so that a call would be less impactful.

Summary

We as investors tend to focus on stocks due to their higher return profiles and volatility of results. We also believe fixed income is a valuable part of a balanced portfolio. Given a lower rate environment and the higher inflation backdrop, there are still ways in fixed income to generate sustainable sources of income. Preferred stock as part of a portfolio may give a boost to the overall yield.

Part of our firm’s strategy is to help bolster your portfolio while balancing relative risk and reward by investing capital in fixed income. As always, this approach may be subject to change if offerings don’t meet our standards in terms of attractive yield relative to risk.