Fixed income investments have generally played two key roles within a diversified asset allocation—generating a stable income and providing protection during equity market selloffs. While we still think high-quality fixed income investments can meet those two objectives, with yields as low as they are, the income objective has certainly become harder to meet. As such, income-oriented investors may have to look to non-core fixed income alternatives.
An alternative option worth considering may be preferred securities. As seen in the LPL Chart of the Day, preferred securities are amongst the highest yielding options within the fixed income categories. Following are five things investors should know before allocating to preferred securities.
- Hybrid securities. Preferred securities are “hybrid” securities that can be classified as either equity or debt within a company’s capital structure. They are senior to common equity but junior to traditional debt. As such, they don’t have the same capital appreciation potential of common equity nor do they possess the same capital preservation benefits of traditional debt. Preferred securities, then, tend to offer higher coupon payments to attract investors.
- Financial focus. The majority of issuance comes from financial institutions. Preferred securities are highly correlated with the health of the financial system and a shock to the financial system would adversely impact these securities.
“Preferred securities can be higher yielding alternatives to traditional core fixed income options. They are concentrated in the financial sector but since the global financial crisis, many financial institutions have emerged with stronger balance sheets, which should limit downgrades and defaults,” according to LPL Financial Fixed Income Strategist Lawrence Gillum.
- Credit risk. The securities tend to be BBB- or BB-rated, which means they carry higher levels of credit and default risks than the senior debt issued by the same issuer. However, since the issuers of preferred securities tend to be higher quality companies, default rates have been lower than similarly rated non-financial corporate bonds.
- Multiple markets.S. preferred securities trade in two separate markets and while the issuer is the same, the security structures can be different. The $25 retail market is an exchange-traded market where the securities pay quarterly dividends, whereas the $1000 institutional market is an over-the-counter traded market where the securities pay dividends semi-annually.
- Diversification benefits. Given the hybrid nature of preferred securities, there are diversification benefits to adding preferreds to a portfolio. While these securities tend to “act” like equity and high-yield fixed income securities across a full market cycle, since the financial crisis in 2009, these securities have generally held up better than both during equity market sell-offs (as measured by the S&P 500 Index).
With yields low within traditional fixed income sectors, the income component within fixed income has been harder to come by. For those income-oriented investors willing to take on some additional credit risk, preferred securities might be an attractive investment to consider.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.
References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.
Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities. All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.
All index and market data from FactSet and MarketWatch.
This Research material was prepared by LPL Financial, LLC.
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