Preferred Securities
Today, preferred securities take many forms. In general, there are three types of preferred securities: traditional perpetual preferreds, trust preferreds and debt securities. Potential investors should examine the characteristics of each issue to determine that the investment meets their expectations and risk tolerance. They should understand the capital structure for priority of claims, study call provisions and know the circumstances under which the issuer can stop paying out income as well as what the consequences are. As approximately 80% of preferred securities are issued today by financial firms, rendering creditworthiness is of the utmost importance in addition to limited sector diversification.
Investment Highlights
- Income – Preferred securities generally offer fixed periodic payments. However, payments can be interrupted under certain scenarios that are discussed below.
- Competitive Returns – Preferred securities may offer attractive yields compared to other fixed income investments.
- Term – Most preferred securities carry a defined investment timeframe; however, some issues are perpetual. Usually, the investor has call protection for five years from the issue date although extraordinary calls may exist.
- Quality – Preferred issues are generally rated by the rating agencies based on the issuer’s credit quality. In general, higher yields are associated with lower quality issuers. In the capital structure, they usually fall at the bottom of the balance sheet between common stock and debt.
- Liquidity – Most issues are traded on the major exchanges.
- Diversification – A diversified portfolio including fixed income and preferred securities may help to reduce risk and mitigate the effects of market volatility.
- Denomination – Most issues are offered in $25 par value denominations.
Suitability
Preferred securities are most suitable for investors with long-term time horizons who are interested in a fixed rate of return. As new structures continue coming to the market, not all issues may be suitable for a particular investor. The following explanations should be used in conjunction with a prospectus, as features may differ from issue to issue. The explanations below should assist investors in determining personal suitability, and risks and rewards of investing in preferreds.
Features, Considerations and Risks
- Returns – To evaluate the attributes of preferred securities, an investor must understand the pricing mechanism. These securities trade at a price that can include up to three components: par value, accrued dividend or income from the last payment date, and market premium or discount. As with bonds, preferreds should be evaluated based on the worst-case scenario. If purchased at a discount, current yield, yield to maturity or perpetuity are of significance. Yield to call is significant if preferreds trade at a premium as the issuer is more likely to call the security prior to its term. At par, the yield is the dividend or coupon.
- Income – All preferred securities have an income feature based upon par value that is paid monthly, quarterly or semiannually. In simplest terms, traditional preferreds pay dividends, while trust preferreds pay interest; however, these income payments are dependent on the issuer’s financial condition. The issuer will have to stop paying the common stock dividend before it would stop the payments on preferreds. For traditional preferred stock dividends, the payments must be declared by the Board of Directors. The deferrable feature on certain trust preferred shares may have a negative impact on investors’ tax liability. On trust preferreds or capital trust structures, the issuer may defer payments up to five years, ten years or longer without causing a default event. If deferred, the holder is liable for tax on income accrued but not received. Preferreds can also be cumulative or non-cumulative. In these instances, if the issuer stops making payments, cumulative shares will have to catch up and pay dividend or interest payments. Deferrable issues may have an alternative payment mechanism or provision that requires the issuer to sell assets to pay the deferred payments after a certain period. Some issues have a fixed to float feature that allows for the income to float based on a certain benchmark after paying a fixed rate for a specified period. Changes in income payments may significantly affect yield and final term of the investment and, consequently, the price may decline significantly.
- Term of Investment – Most preferred securities carry maturities of 20 - 49 years from the original issue date, but some are perpetual. While most preferred securities become callable after a period of call protection, certain extraordinary events may further alter the term of investment. Special event calls may be in place to allow the issuer to call the securities early. These events may include a tax law change, capital treatment event, rating agency event or a regulatory call based on change in status of the issuer or a call on the underlying collateral. Further, a few issues with a defined maturity date may have provisions for maturity extension. These features are discussed in the prospectus and should be reviewed carefully as they may impact the final return on the investment.
- Credit Risk – The yields offered will depend upon the issuer’s credit quality. In general, lower quality issuers will require higher yields to compensate the investor for credit risk. If the issuer’s credit quality changes, the security’s value could be affected as well. Income-oriented investors should consider preferreds that carry investment-grade ratings. In case of default, priority of claim is an important consideration.
- Priority of Claim – Preferred securities provide the investor with a higher priority of claim on the assets than common stockholders should the issuer be liquidated. The priority in the capital structure of a corporation is as follows: (1) secured debt, (2) unsecured debt, (3) unsecured subordinated debt, (4) trust preferred securities, (5) traditional preferred stock and (6) common stock. Consequently, preferreds fall at the bottom of the balance sheet just above common stock.
- Interest Rate Risk – Preferred shares are fixed income securities that, like bonds, have values that rise and fall in response to interest rate changes. Principal is subject to market fluctuations, which can be significant at times, and sale proceeds may be more or less than the original purchase price. As preferred securities have long-term maturities, an increase in interest rates will have a considerable impact on the principal value. If rates rise, preferred prices typically decline because the income rate is less attractive relative to new issues of similar preferred securities. Conversely, when interest rates decline, the income rate available on a previously issued preferred generally becomes more attractive, and demand drives the price up. However, if the securities are callable, a decrease in interest rates will not have as much impact, given that issuers are more likely to call securities in a decreasing interest rate environment. In addition, preferred securities trade at a price that includes income accruals. All other variables being equal, the preferred price should increase accordingly to reflect the accrued income. Other factors affecting the price include supply, demand, credit risk and structure.
- Liquidity – Most preferred issues are traded on a major national exchange, which allows more flexibility in managing a portfolio, and are quoted in many major newspapers with a “pf” following the underlying stock symbol.
- Taxation - Only traditional preferred stocks carry dividend received deduction (DRD) under which “qualified” domestic corporations receive a tax advantage. In the marketplace today (as of August 2010), there are a few traditional preferred stocks. For other preferred securities, there is no tax-advantage for qualified domestic corporations. Based on current tax law, certain types of preferreds qualify for qualified dividend income (QDI) until December 2010. However, investors should not rely on this provision, as it may change.
As discussed above, the deferrable feature on certain trust preferred shares or capital trust structures may have a negative impact on investor’s tax liability as the issuer may defer payments up to five years, ten years or longer without causing a default event. If payments are deferred, the holder is liable for tax on income accrued but not received. - Diversification – Although a diversified portfolio including preferred securities may help to reduce risk and mitigate the effects of market volatility, diversification in itself does not ensure a profit or protect against a loss. Investments are subject to market risk, including possible loss of principal.
Preferreds at a Glance
| Traditional Preferred | Trust Preferred Security | Debt Security | |
|---|---|---|---|
Priority of claim |
Junior to all debt, senior only to common equity |
Junior to all debt, senior to traditional preferred and common equity |
Senior to trust & traditional preferreds and common equity |
Income |
Dividend |
Interest income |
Interest income |
Cumulative or non-cumulative |
Cumulative or non-cumulative; |
Few permit deferral of income but at some point the event may cause default |
|
Paid out of after-tax earnings |
Paid out of pretax earnings |
Paid out of pretax earnings |
|
Term |
Perpetual |
Usually 30 years or longer |
Usually 30 years or longer |
Usually five years non-call from issue date |
Usually five years non-call from issue date |
Usually five years non-call from issue date |
|
Special calls may exist |
Special calls may exist |
Special calls may exist |
Structure of Traditional Preferreds
Traditional preferred stocks are stock shares that represent a portion of ownership in a company, with the shares normally carrying fixed dividends. Sometimes, but not generally, the shares have voting rights. Typically issued with a $25 par value, they provide the investor with the liquidity associated with an exchange listing, and trade flat but at an aggregate price that includes market value and accrued income.
Structure of Trust Preferred Securities
A trust preferred security is a hybrid of corporate bond – which generally carries a stated maturity, gives the holder a claim on issuer assets that is above both common and traditional preferred shareholders, and trades with accrued income – and a preferred stock – which is issued with a $25 par value, provides the investor with the liquidity associated with an exchange listing, and trades at a flat but aggregate price that includes market or par value and accrued income.
The issuers of trust preferred securities are often the same companies that issue other traditional debt instruments such as bonds. Trust preferred securities may be issued by the same company that is obligated on the underlying security or by a third party.
Third-party trust preferred issues are usually collateralized with the assets of another issuer and do not have the underlying issuer’s guarantee. They may also be subject to call provisions at a price less than par. Some commonly used acronyms for these repackaged trust preferreds follow: CBTCS™(Corporate Backed Trust Certificates), CORTS™ (Corporate Backed Trust Security), MIPSSM (Monthly Income Preferred Shares), MIDSSM (Monthly Income Debt Securities), PCARS (Public Credit and Repackaged Securities), PPLUSSM (Preferred Plus Trust), QUICSSM (Quarterly Income Capital Securities), QUIDSSM (Quarterly Income Debt Securities), QUIPSSM (Quarterly Income Preferred Securities), TOPrS™ (Trust Originated Preferred Securities), TRUPS (Trust Preferred Securities). (SM = service mark, ™ = trademark)
Possibility of Capital Gains/Losses
A holder of preferred securities will generally recognize a gain or loss on the sale or other disposition of the securities. Factors affecting the price include interest rates, credit quality and structure. Decreasing credit quality or interruption of income payments due to a deferral feature and/or call potential may significantly depress the price even in a decreasing interest rate environment. The resulting capital gain or loss will depend on the difference between the cost basis and net sale proceeds. In the case of trust and debt preferred securities, purchase and sale prices may reflect accrued income that may have been included. Please consult your tax advisor for details.
Sample Calculation of Adjusted Cost Basis for Trust or Debt Preferred Securities*
| Transaction # 1 | Transaction # 2 | |
|---|---|---|
Transaction Price |
$25.65 |
$25.25 |
Accrued Income |
$- 0.40 |
$ - 0.40 |
Adjusted Cost Basis |
$25.25 |
$24.85 |
Security Par Value |
-$25.00 |
-$25.00 |
Market Premium(Discount) |
$ 0.25 |
($ 0.15) |
*This is a hypothetical example presented for illustrative purposes only. It does not relate to any specific security.
Although both transactions occurred above the stated par value of $25, one reflects a possible market premium and the other reflects a market discount.
Explanation of Commonly Used Terms
Alternative Payment Mechanism/Mandatory Payment Provision/Payment Securities – The issuer is obligated to pay deferred payments with proceeds from the payment securities as provided in the prospectus (such as stocks and warrants).
Capital Replacement Covenant – Prior to maturity, the issuer may call capital securities with proceeds of like junior securities and as long as it does not impact senior security holders in priority of claim. In certain cases, prior regulatory approval may be required. This may occur at any time, for example, if the issue no longer qualifies as Tier 1 capital.
Dividend Stopper – Unless the issuer has paid the cumulative deferred interest, the issuer will not take action to make payments on junior securities.
Investment Company Event – Change of regulation that requires the issuer of a preferred to be considered an investment company that must be registered under the Investment Company Act of 1940.
Make-Whole Call – A provision that allows the issuer to prepay the issue at the greater of par or par plus a designated spread over a Treasury.
Mandatory Deferral of Interest – Issuer is required to defer interest payments in the event of inability to pay debts to senior creditors, if liabilities exceed assets, or in case of a regulatory minimum capitalization event, supervisory event, or wind-up due to liquidation. Interest will not be cumulative in these instances, and thus will present no tax liability to the holder.
Optional Deferral of Interest – Issuer may choose to defer payments – but payments generally will be cumulative. Holders will be liable for tax on income accrued but not received (phantom income). Under these circumstances, the issuer will not make payments on junior securities. After a given period, typically five years or longer, the issuer may be required to sell designated assets such as common stock or warrants to make deferred payments. Any deferral of payments may cause the shares to trade at a significantly lower price. In most instances, the issuer has the right to defer payments for 10 years without causing an event of default.
Rating Agency Event – A change in the rating agency treatment of capital securities may trigger a call.
Tax Event Call – Upon occurrence of certain tax events, such as a change that would impose tax on the issuer, the issuer may be able to convert or exchange for a like security or call the entire issue. Usually the entire issue would be called and it can be done prior to the traditional five-year non-call period.
Voting Rights – Preferred securities do not generally have voting rights except in special circumstances.