Why we think preferred securities look strong after the 2023 bank failures

We have been constructive on preferred equities over the past few years as a way for investors to invest in higher-yielding assets. Broadly, preferred securities have a mix of bond and equity-like features, offering investors an opportunity to invest in high-quality companies with the potential for returns and price appreciation.

Why might they be attractive now? Preferreds combine higher returns by higher-quality companies than U.S. high yield companies. Preferreds currently yield 6.95%, 15 basis points (bps) higher than BB high yield, while the credit quality of the issuing company is significantly higher with an average of A2 issuer ratings vs BB rated high yield¹. Preferreds also may receive favorable tax treatment that further enhances their value for U.S. taxpayers.

Given the increase in interest rates in 2022–23, banks² are now issuing new preferred securities with coupon rates that provide investors with average tax-equivalent current yields over 7%.³ This is on par with historic returns in the equity market. ⁴ In addition, the banking failures in early 2023 caused volatility in the space, and some contagion spread to non-bank preferreds. This created value in issuers that have little or no exposure to the troubles of the failed banks.

Preferreds of all sorts have staged a substantial recovery in the last year. Our view: Given their characteristics and prices today, we think this market is still compelling. Here’s what makes them worth looking into right now.

Underappreciated market

The U.S investment grade bond market is about $8.4 trillion, the leveraged loan market is $1.4 trillion, and the high yield bond market is $1.3 trillion. The market for preferreds is smaller than any of those, at less than $1 trillion.⁵ We feel the space is somewhat overlooked, given what it can do for an investor’s portfolio.

Appealing yields

Even beyond global banks, preferred equity yields remain elevated and attractive on a historical basis. Preferred yields as measured by the benchmark PVAR Index are currently at 6.8%—down from 10% during the 2023 bank failures, but well above their long-term average of 5%.

Attractive dividends

Preferred equities typically pay regular dividends. Most often, they pay a fixed quarterly or semiannual dividend for a set period, such as five years.⁶ When that period ends, the issuer can call the shares and issue new ones or continue paying dividends at a floating rate that has reset to a benchmark rate, such as the Secured Overnight Financial Rate (SOFR) or five-year U.S. Treasuries. Most often, issuers call their preferreds.⁷

Favorable tax treatment for some investors

In the United States, dividends on preferred securities are taxed like qualified dividend income,⁸ at a federal rate of 15% or 20%. This means investors whose incomes put them in tax brackets with rates of up to 37% will most likely pay lower taxes on the income they get from preferreds than on income from other investments, including high yield bonds.

While high yield bond returns tend to look larger on paper, the potential tax advantages of preferred securities are significant, and can provide them superior yields on a tax-equivalent basis.⁹

Typically high-quality company issuers

High yield bonds offer higher coupons/yields than investment grade bonds or Treasuries because they are issued by riskier companies, with greater probability of default. In contrast, the companies that issue preferreds tend to have much less default risk. Preferreds are generally issued by higher-quality companies; issuers typically have investment grade credit ratings. U.S. banks, especially the systemically important ones, are highly regulated and have conservative balance sheets.

Since defaults can erode an investor’s returns in the high yield space, we think this combination of the potential for higher returns and higher quality makes preferreds attractive in comparison to high yield bonds.

A clear recovery in the space 

The 2023 failures of First Republic and Silicon Valley Bank damaged financial stocks generally. Preferred equities suffered as well.

However, there has been a clear recovery in the space since then, led by global banks of systemic importance. Many investors see these banks as lower-risk investments because of the high quality of their businesses and the large amounts of capital that regulators require them to hold.

We like these institutions as investments because they typically have a greater provision for losses, diversified revenue sources and limited exposure to the risks associated with commercial real estate offices. They gained 8% in 2023 and another 3.78% year-to-date, but we don’t think the run is nearly over.