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16 A A I I J o u r n A l NOV E M B E R 2 0 2 1
P O R T F O L I O S T R AT E G I E S
The firm’s ability to defer dividends increases the risk of
these securities relative to senior debt. However, dividends
on preferred shares due in the current period—and also,
in the case of cumulative preferred shares, any unpaid
dividends from prior periods—must be paid before any
dividends can be paid to common shareholders. Unlike
coupons on most bonds, dividends on many preferred
shares are qualified, and
are taxed at an advanta-
geous qualified dividend
income (QDI) rate, rather
than as income, to the ben-
efit of investors who hold
them in taxable accounts.
(Preferred stocks must be
held for a consecutive min-
imum of 90 days during a
181-day period beginning
90 days prior to the ex-
dividend date to qualify for the reduced tax rate. This is a
longer period than the one that applies to common stocks.)
Types of Preferred Stock
Most preferreds are issued by financial firms, and
carry a par value of $25, although some carry a par value
of $1,000, like senior debt. The market consists of several
types of securities, including:
» traditional preferreds, which have perpetual lives
and are non-cumulative;
» baby bonds, which are, in effect, senior bonds, with
the same risk but $25 par value;
» hybrids, which are cumulative, and rank above other
preferred securities and common equity; and
» contingent convertibles (CoCos), which are convert-
ible bonds in reverse. Generally issued by foreign
banks, these are bonds that convert to equity when
the stock price falls, rather than rises. This typically
occurs when the financial institution is under stress,
so that the CoCo provides additional equity capital
to absorb losses.
As with bonds, purchasers of preferred securities must
pay for any accrued interest, and it is usual for a “dirty
price,” which includes accrued interest, to be quoted.
The price will drop on the ex-dividend date to reflect the
Preferred Stocks
Explained
As a hybrid security, preferreds have higher
yields than bonds and offer an attractive
risk/return tradeoff for investors searching for
yield.
BY BRIAN HAUGHEY, CFA, FRM, CAIA
In the June 2021 AAII Journal, I discussed con-
vertible bonds, which possess both fixed-income and
equity characteristics (“Inside Convertible Bonds: An
Attractive Risk/Return Tradeoff”). Preferred securities
(aka preferred stocks, or preferreds) are a related type of
hybrid. They share some features of bonds in that they
offer scheduled payments on a fixed par amount and
carry a credit rating. Their risk profile is closer to that of
equity, however. As such, they have higher yields than
bonds and offer an attractive risk/return tradeoff for
investors searching for yield.
An Overview of Preferred Stock
Like common stock, preferred securities represent an
ownership interest in the firm, although generally with-
out voting rights. (Some firms do assign preferred share-
holders voting privileges in extraordinary circumstances.)
Preferred shareholders do have a higher claim than com-
mon stockholders to the assets of a firm in the event of its
bankruptcy, although their claim is subordinate to those of
bondholders.
Dividends on preferreds are typically fixed, like bond
coupons. Preferred dividends are larger than those on com-
mon shares, although the latter tend to increase over time
as the firm’s fortunes improve. Dividends on participating
preferreds may also increase, but typically only when a
firm is being wound up. Furthermore, as with convertible
bonds, convertible preferred shares can be converted into
common stock, thereby allowing the investor to benefit
from price appreciation. In contrast to bonds, whose cou-
pons are typically paid semiannually, preferred dividends
are paid quarterly and are not contractual. A firm’s failure
to pay preferred shareholders a dividend is not an event of
default.
Brian Haughey, CFA, FRM, CAIA, is a
contributing editor to the AAII Journal. He is
an assistant professor of nance and director
of the Investment Center at Marist College in
Poughkeepsie, New York. Find out more at
www.aaii.com/authors/brian-haughey.
Unlike coupons on most
bonds, dividends on many
preferred shares are
qualified, and are taxed at
an advantageous qualified
dividend income (QDI) rate,
rather than as income, to the
benefit of investors who hold
them in taxable accounts.
© 2021 by the American Association of Individual Investors, 625 N. Michigan Ave., Chicago, IL 60611; (312) 676-4300.
A A I I J o u r n A l N OV E M B E R 2 0 2 1 1 7
A A I I . C O M / J O U R N A L
4.0 indicates that the ETF could be expected to decrease in
price by about 4% in response to a 1% increase in interest
rates.
Credit Risk
When investing in preferred securities, either directly
or via an exchange-traded fund (ETF), it is important to
study and understand their credit risk. Most preferred
securities are assigned a credit rating, which can range
from AAA (the highest quality) down to D (currently in
default). Ratings from AAA through BBB- are considered
investment grade, while those with ratings below BBB- are
non-investment grade and are substantially riskier. The
majority of preferreds are rated BBB and below. Accord-
ing to the company’s website, for instance, the Invesco
Preferred ETF has 54% of its assets in securities rated as
investment grade by S&P, with the remainder either non-
investment grade or not rated.
Since preferreds have a claim on assets that is lower
than that of the issuing firm’s bonds, they are riskier, as
shown in Figure 1.
For example, Citigroup Inc. senior debt is rated BBB+
by S&P. However, Citigroup also has several classes of pre-
ferred shares outstanding, including Series K, which are
perpetual, non-cumulative preferred shares that are call-
able in November 2023. The Series K preferreds (ticker
C-PK) are rated BB+. Since the preferreds are riskier, they
should offer higher returns than senior bonds. They should
offer lower returns than common stock, though, since they
have lower risk due to their higher claim on assets.
dividend payment just made, as the price of dividend-
paying common stock also does.
Just as there are floating-rate bonds, floating-rate
preferreds pay a variable dividend, typically with a floor, or
minimum payment. Fixed-to-floating rate preferreds pay
a fixed dividend for a specified number of years (typically
five years) after issuance. After this period has passed,
fixed-to-floating rate preferreds switch to paying a float-
ing dividend (if not called by the issuer). Floating dividends
are set at a spread to a reference rate such as three-month
LIBOR (London Interbank Offered Rate), which is likely, in
the next year or two, to be replaced by another rate such as
the Secured Overnight Financing Rate (SOFR).
While bonds have a fixed maturity, preferred shares tra-
ditionally have had perpetual lives, although many nowa-
days may be redeemed after a specified number of years.
Term preferreds have a mandatory redemption feature,
which means that in practice they have a maturity date.
The Call Feature of Preferreds
Most preferred securities have a feature that enables
the issuer to call them on specified dates. Similar to a call
option on stock, the option is likely to be exercised when
the securities trade at a premium.
Since preferreds with fixed dividends tend to look
increasingly attractive when interest rates decline, these
will likely be called if rates remain low or decrease. The
likelihood of a call depends also on the credit quality of the
issuer, and the refinancing cost they would face, as well as
the provisions of the specific issue.
Interest Rate Sensitivity
Preferred shares that have fixed dividends tend to
behave like bonds, with their prices moving in response to
changes in interest rates. Just as bond price sensitivity to
interest-rate changes is a function of maturity, term pre-
ferreds will tend to have relatively low price volatility in
response to interest rate changes, since they act like short-
term bonds.
Floating-rate preferreds,
on the other hand, will have
almost no rate sensitivity
since their dividends adjust
with changes in short-term
interest rates. The Invesco
Preferred ETF (PGX), for
instance, has a modified
duration of close to 4.0,
lower than the 4.8 of the cur-
rent five-year U.S. Treasury note. A modified duration of
FIGURE 1
Capital Structure of Corporations
Floating-rate preferreds, on
the other hand, will have
almost no rate sensitivity
since their dividends adjust
with changes in short-term
interest rates.
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18 A A I I J o u r n A l N OV E M B E R 2 0 2 1
Comparative Performance
Figure 2 compares the performance of Citi-
group securities during the period from Decem-
ber 31, 2019, until September 30, 2021, through
the coronavirus pandemic. You can see that the
common stock, shown in orange, suffered a pre-
cipitous decline of almost 55% in March 2020. The
Series K preferred shares outperformed the com-
mon stock over this tumultuous period because
of their comparatively lower bankruptcy risk and
their priority with regard to payment of dividends.
It is interesting to compare the performance
of preferreds against high-yield bonds and short-
term bonds. Figure 3 illustrates the relative perfor-
mance over a 10-year period ending September 30,
2021, of the iShares iBoxx $ High Yield Corporate
Bond ETF (HYG), the Vanguard Short-Term Bond
ETF (BSV) and the Invesco Preferred ETF. The pre-
ferred shares ETF outperformed, as one might
expect, with an average annual return of 6.92%,
while the high-yield ETF returned 6.17% and the
short-term bond ETF returned 1.74% annually.
However, it is worth noting that during the
sub-prime crisis, from January 31, 2008, through
December 31, 2009, while the high-yield and
short-term bond ETFs both had cumulative posi-
tive returns of close to 8%, the Invesco Preferred
ETF underperformed, with a cumulative total
return of –21%. This drop was even worse than the
S&P 500 index’s total return of –15%. While we
might expect preferreds to offer better returns in
a bear market, they won’t always do so. During the
sub-prime crisis, preferred performance was likely
adversely impacted by their overexposure to the
financial sector. Indeed, over the same period the
S&P 500 Financials Index returned –47%.
Final Thoughts
Preferred shares combine some of the bene-
fits of bonds (credit ratings and fairly predictable
income) with the extended maturity and higher
returns of equity-type investments. They can offer
higher yields than bonds, tax advantages relative
to bonds, and a means of diversification due to
their low correlation with other asset classes.
However, there are some nuances that investors
should note. Firms in high-growth sectors don’t
tend to pay dividends, or issue preferred shares.
An allocation to preferreds will, therefore, tilt
your portfolio away from these sectors and toward
financial and utility companies, which account for
FIGURE 2
Total Return for Citigroup Common and Preferred
Stock During Pandemic
During the coronavirus pandemic period of December 31, 2019,
through September 30, 2021, Citigroup Inc.’s Series K preferred
shares outperformed shares of the company’s common stock because
the preferred stock had comparatively lower bankruptcy risk and
higher priority with regard to payment of dividends.
FIGURE 3
10-Year Performance of Preferreds, Short-Term
Bonds and High-Yield Bonds
Relative 10-year performance of the iShares iBoxx $ High Yield
Corporate Bond ETF (HYG), the Vanguard Short-Term Bond ETF (BSV)
and the Invesco Preferred ETF (PGX) from September 2011 through
September 2021.
-60%
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
Common Preferred
Source: Yahoo Finance.
Source: Yahoo Finance.
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
HYG BSV PGX
(continued on page 23)
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P O R T F O L I O S T R AT E G I E S ( C O N T I N U E D F R O M PAG E 18 )
the majority of preferred issuance.
Liquidity, or trading volume, tends to be thin, so if you
are buying shares in individual firms, you should make use
of limit orders. Indeed, because of the security-specific call
and other provisions, as well as the thin trading, an ETF
or closed-end fund is the best vehicle through which to
gain access to this sector for all but the most sophisticated
investors. ▪
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