This Overlooked Fixed-Income Vehicle Pays High Yields

In a bond market where corporate yields are a shadow of their former selves and Treasury yields begin with naught, investors are beating the bushes for vehicles with better income.

Tax-free municipal bonds have long been a desirable refuge for well-heeled investors, but the munibond market is now darkened by a cloud of potential risk from the coronavirus pandemic.

Many of these investors would do well to consider preferred shares, an asset class that’s overlooked even though it’s currently paying the highest after-tax yield of any fixed-income investment except corporate junk bonds.

Though traded as shares of stock, preferred shares in many ways act like a bond. But unlike bonds, their yield is mainly in the form of qualified dividends--a key reason for their superior after-tax yields.

Issued mainly by banks, insurance companies and large financial firms, preferred shares fulfill different corporate financing goals. For investors, they can be an effective portfolio diversifier that delivers reliable income. If the worst happens and the issuing company tanks, preferred shareholders line up behind bondholders, but ahead of equity shareholders, for payment.

For shares of preferred stock in issues of intermediate duration, annual total yields in June averaged 5.1%. Most of this is qualified dividend income, on which individuals in the top bracket pay a tax rate of 20%, as opposed to the hurtful ordinary income tax rate of 37% that they pay on bond and short-term stock gains.

Preferred shares’ after-tax yield of 3.6% is substantially above the yield of tax-free municipal bonds--2.7%--and corporate bonds’ after-tax yield of 1.4%. And it’s not far below the 4.1% after-tax yield of junk bonds, considering that preferred shares have a critical advantage over them: better credit quality.

What counts most regarding preferred share credit is the issuing company, rather than any particular issue. It’s the nature of the beast for a company’s preferred share issues to have credit quality a few notches below that of the overall credit of the company itself. Preferred investors need to worry about the credit quality of the issuing company versus that of individual issues. If they buy the preferred shares of high-quality companies, they don’t need to worry about where they would stand in a bankruptcy line because staying away from companies with poor credit makes this consideration moot.

Muni Credit Quality Questions

Questions about near-term credit quality currently surround munibonds because the local and state governments that issue them are experiencing negative impacts from the coronavirus—the double-whammy of less revenue and higher costs to deal with public health and safety measures. Top-rated muni issues, AA and above, are better able to weather storms, and concerns about risk center more on munis of lower credit quality. As of mid-July, rating agencies hadn’t downgraded munibond credit ratings over pandemic-related fiscal damage, presumably out of expectations that Congress will provide more fiscal support. Nonetheless, markets are watching the ratings closely.

To assess risk on an issue-by-issue basis, individual investors buying munis need to know the source of funds for paying interest. For example, a munibond that depends on revenue from a parking garage tied to a sports arena might have trouble meeting its obligations if games and concerts are cancelled due to the pandemic. But if interest payments come entirely from local government coffers, then concerns would center on the fiscal health of that government.

Strength of Preferred Share Issuers

By contrast, preferred share investors currently don’t have such credit quandaries because institutions issuing are in good shape with good outlooks. Consider these scenarios:

• Banks have long met the Fed’s stress-test requirements spawned by the financial crisis of 2008. And on June 25, 2020 the Fed issued stress test results showing that banks are “a source of strength” amid the pandemic. Even if banks begin to show weaknesses, the Fed’s actions in 2008-09 indicate a likely willingness to shore them up again to protect the economy. Moreover, most big banks currently have good balance sheets and profitability, enabling them to continue paying dividends to preferred shareholders.
• There’s a low probability that insurance company issuers will have to pay claims related to the pandemic because efforts to retroactively define policy terms to trigger such liability seem likely to fail.
• The financial services sector continues to be fortified by high international demand for U.S. securities, meaning good revenue ahead for large financial services firms issuing preferred shares.

However attractive preferred shares are right now, there’s a limit to how heavily the average investor should probably invest in them for a number of reasons. Among these is that credit quality can be confusing. An issuer may have a rating of A2 by Moody’s, but their preferred might be rated Baa2 due to its place in line to get paid back in the event of bankruptcy.

Further, it’s generally not advisable for the average individual investor to have more than 15% of a portfolio in preferred shares, though investors with higher risk tolerances, substantial assets and high income are in a position to go heavier—and may want to during this period of bottom-scraping bond yields.

In allocating resources to preferred shares, investors should be aware of the degree to which their value moves with other asset classes. A correlation of 1.0 means that the value of investments in one asset class tends to vary directly with another. The 10-year monthly correlation of S&P Preferred Total Return Index to the S&P 500 stock index is .65. The preferred index has a .299 correlation to the US Aggregate Bond Index, making preferred shares an even better diversifier against bonds than they are against stocks.

While all investors like superior yield, preferred shares aren’t for everyone because their hybrid nature tends to make them quite complicated. Issues aren’t uniform in nature, issuer versus issue credit ratings can be confusing and information on their various differences and downsides can be difficult to find.

Active Funds Over Passive

Accordingly, it’s best for individual investors to avoid indexes and stick to actively managed mutual funds. Passively managed preferred funds (the category of most preferred ETFs) tend to underperform actively managed funds because, in tracking indexes, they can’t avoid undesirable issues. For investors, this can result in loss of principal, offsetting gains from dividends—a dynamic that has been demonstrated in Morningstar studies. But active managers can avoid these pitfalls by picking and choosing between issues. For investors, avoiding the indexes is usually well worth the expense of active management.

While fund shareholders can benefit from active management, choosing funds involves its own complexities. Some function as closed-end funds, meaning that shares can only be sold on an exchange, perhaps at a discount to net-asset-value. And many closed-end funds employ leverage, further exacerbating price movement, so research before buying is critical.

Also, many funds that bear the “preferred” moniker invest in more than just preferred shares. Many also trade various complex forms of debt that are esoteric to the average investor and fall into the broader category of “preferred securities.” This can present individual investors with a steep learning curve.

Yet, for individual investors willing to do the homework to expand their knowledge of the vast fixed-income world—or for those who have qualified advisors to guide them through it—preferred shares and actively managed funds can be used effectively to garner superior after-tax yields with relatively low risk.

Dave Sheaff Gilreath is a founding principal and J.R. Humphreys is a senior portfolio manager with Sheaff Brock Investment Advisors LLC, an investment management firm based in Indianapolis. The firm, which Gilreath started with partner Ron Brock in 2001, started out managing $60 million in assets, which have since grown to about $1 billion. Gilreath is a Certified Financial Planner®.

Humphreys is a Chartered Financial Analyst® and a Chartered Alternative Investment Analyst.