UBS Financial Services said interest rates are falling but investors can still find some solid income opportunities in preferred securities markets. Preferred securities combine the attributes of bonds and stocks. They trade publicly on an exchange, but also pay out revenue quarterly. Issuing companies are typically banks and utility companies. The yields on these instruments can reach over 5%, and this income may have tax advantages for investors. Generally speaking, coupons are taxed at the same rate as qualified dividends, which is 0%, 15% or 20%, depending on the investor’s taxable income. Meanwhile, bond interest income is taxed as ordinary income, which means its tax rate is as high as 37%. Retail Investors and Preferred Stock Preferred securities sold to retail investors have a fixed par value of $25. The coupon can be fixed for the entire term, or it can be “fixed to floating,” meaning the interest rate adjusts after a specified period. While many preferred stocks have long or perpetual maturity dates, they often have a “call date” after which the issuer can redeem them. In a falling interest rate environment, issuers may call in preferred shares, leaving investors scrambling to find replacement securities. Frank Sileo, senior fixed income strategist at UBS, said such activity is more prevalent in the $1,000 denomination market because those securities tend to have variable-rate coupons, while the $25 denomination market tends to be mostly fixed-rate. Likewise, investors who bought preferred stock at a discount and redeemed it at par may have enjoyed receiving the proceeds but now face reinvestment risk, Sileo added. They may have difficulty finding assets with comparable yields. Additionally, true perpetual security preferred stocks have higher interest rate sensitivity, leading to price volatility, Sileo said. “When interest rates go down, prices will appreciate, and they will appreciate a lot, and when interest rates go up, prices will depreciate,” he said. “People sometimes say, ‘I buy them for income, I don’t care about price fluctuations.'” — until that happens,” Sileo said. “Then you’re going to have unrealized losses in your statement, and that can be uncomfortable.” Another risk to consider is that investors who hold preferred stock have a lower priority in the company’s capital structure than bonds. holder. If an issuer is liquidated, holders of preferred stock rank lower than bondholders but higher than common stockholders, who typically get wiped out. It also means investors should know the issuer’s credit rating before buying preferred shares. Standard & Poor’s considers companies with a credit rating of BBB- or higher to be investment grade. Investors who would rather buy a basket of preferred stocks that can invest in different companies might consider exchange-traded funds. The iShares Preferred and Income Securities ETF (PFF) has an expense ratio of 0.46% and a total return (including reinvested dividends) of more than 11% in 2024. There’s also the First Trust Preferred Securities and Income ETF (FPE), which has an expense ratio of 0.84% and a total return of 12% in 2024.
