Preferred Securities: The Overlooked Fixed Income Alternative

Explore why the market has quadrupled since 2005. One reason: historically attractive yields of about 5%. Another: the income may qualify for a tax-advantaged rate.

Preferred Securities: The Overlooked Fixed Income Alternative

EXHIBIT 1: PREFERRED SECURITIES PRODUCT GROWTH

Total Assets (MFs, EFTs & CEFs)

10

20

30

40

50

60

70

80

90

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Bill

ions

Source: Allianz Global Investors US LLC

Preferred securities play a unique role in investment portfolios while occupying a special place in corporate capital structures. These hybrids feature characteristics of both stocks and bonds, making them an attractive complement to “pure” equity and debt securities. Now may be a good time to consider this often-overlooked asset class and explore whether an allocation might be appropriate in the context of an investor’s risk and return objectives.

Preferreds are a relative niche investment class, but their growing popularity reflects their appeal to investors seeking a level of potential risk and reward between equity and debt securities, while providing issuers with an additional source of capital.

Like stocks, preferred securities issued to retail investors trade on major exchanges. They have the potential to rise or fall in value but generally exhibit less volatility than the issuer’s common shares. And, preferred shareholders have a prior claim over common stockholders to the corporation’s assets in the event of a liquidation.

Like bonds, preferreds provide investors with current income through recurring payments, which may be fixed or floating. Preferred shareholders stand in line ahead of common shareholders for dividend payouts, whose yield is generally higher than the dividend yield on the issuer’s common stock.

In this white paper, preferred securities are described and compared to other income-producing securities on the basis of yield and quality; their correlations to other major asset classes; the characteristics that make them exhibit less interest rate risk; and their potential tax advantages. The issuer landscape by industry group and investor segment is also reviewed. Finally, key attributes that may render one preferred issue more suitable for an investment portfolio than another are defined, making the case for active management among these securities.

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A Brief HistoryPreferred securities were first introduced in the 19th century to help finance the completion of the railroads and canals. New investors in those projects demanded a priority dividend payment over the existing common shareholders given the significant additional capital financing required to complete the projects and the improbable distribution of common dividends over the near term. The term “preferred” refers to the holders’ payment priority over common stock. Investors ceded their voting rights and the potential for future capital appreciation normally associated with equity in exchange for a preferred income stream and a priority claim on assets, relative to existing shareholders, in the event of company’s liquidation.

Collectively, the market for preferred securities is roughly $1 trillion, a four-fold increase since 20051 but somewhat smaller than the high yield market ($1.6 trillion), both of which are a fraction of the size of the U.S. equity market. 1 S&P Dow Jones

EXHIBIT 2: ISSUER VS. ISSUE (%)

IssuerIssue

6.2

50.0

A

0.0

37.3

AA

93.3

10.4

BBB

Source: ICE BofAML Fixed Rated Preferred as of 6/30/2021, Bloomberg, Allianz Global Investors US LLC

EXHIBIT 3: YIELD-TO-MATURITY COMPARISON

Current YTM (%)

10-Year Treasury

High Yield Bonds

4.60

Preferreds

4.09

Corporate Bonds

2.11

Municipal Bonds

1.00

1.44

Source: Allianz Global Investors US LLC, Bloomberg, ICE BofA Merrill Lynch. Yield to maturity as of 6/30/2021 of ICE BofAML Fixed Rate Preferred Securities Index, ICE BofAML Current 10YR Index. ICE BofAML 3-7 Year US Municipal Securities Index, ICE BofAML US Corporate Index, ICE BofAML US High Yield Master Index.

Frequently OverlookedDespite market growth, an allocation to preferred securities is often missing from investor portfolios. The hybrid nature of a preferred may make it difficult to fit this investment class neatly in either the debt or equity universe. For investors, preferred securities have acted more like bonds. Preferreds have a fixed par amount, make scheduled payments at either a fixed or floating rate, and often carry a rating from a credit rating agency.

In the United States, the preferred market became synonymous with the $25 exchange-listed market, which is dominated by retail investors given the small par size. However, the $25 market is only part of the market available to issuers. A $1000 over-the-counter market also exists, where institutions trade large lots, similar to the bond market.

Like bonds, preferred securities have a fixed par amount, pay scheduled payments either at a fixed or floating rate, and rating agencies often put ratings on them. However, like equity, preferreds have very long terms, often perpetual. They have low payment priority, and may even skip or omit payments to investors. However, this is rare, and occurs only if a company is in financial distress.

All payments to preferreds must be made before any payments to common equity holders. However, similar to canceling a common dividend payment, omitting a payment to preferreds would not stop interest payments for bond holders or trigger a default for them. Given this deferral risk, the market is largely focused on investment grade companies, where cash flow is more stable and probability of default is lower.

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However, most preferred securities are issued with fixed- to-floating coupon structures. The payment structure of variable preferreds reduces their sensitivity to rising rates during the fixed rate coupon period. A security may be issued with fixed coupons for a preset number of years, commonly five or 10 years in the institutional $1000 market, and then convert to a floating rate coupon. The moving rate is set with a spread to a certain benchmark interest rate index for the remaining life of the security or until it is called. (Exhibit 5)

With interest rates moving higher, investors may be concerned about the potential impact on the price and yield of preferreds. However, various features of these securities can help moderate their sensitivity to changes in interest rates.

Preferred securities are typically very long dated or perpetual. When issued, they can have fixed coupons, prevalent in the retail $25 market. Similar to high yield, the higher average coupon rate of preferreds can help offset the negative price impact of rising interest rates.

Potential for Tax-Advantaged IncomeMany preferred securities make payments in the form of dividends, which are taxed at a lower rate for corporations and U.S. individuals, driving comparable after-tax income higher.

A key feature in the structures of preferred shares is the dividends received deduction (DRD) nature of the coupon. Dividends received by C-corporations from related entities may be tax deductible.

EXHIBIT 5: PAYMENT STRUCTURE HELPS LIMIT INTEREST RATE RISK

Coupon typeAmount outstanding

($bn)%

outstanding

Variable 555 70.4%

Fixed 194 24.6%

Floating 19 2.4%

Other 10 1.3%

Total 788 100.0%


Deep subordination and the ability to defer or forego dividend payments are features that generally drive security credit ratings to be three to five notches lower than the issuer’s senior debt. However, on a historical basis, income for preferred shareholders has generally been higher than both the dividend offered on the issuer’s common shares and the coupon payment on its bonds. The yield advantage on a preferred security over the senior debt for the same issuer can be competitive with yields of high yield bonds, often making the preferred class the highest yielding security for an investment grade company – and one of the highest yields within the fixed income markets.

The preferred securities market is largely focused on investment grade companies, where cash flow is more stable, and probability of default is lower. Given issuers are generally higher-quality companies, preferreds offer the potential for income similar to high yield but with a lower probability of default. (Exhibits 2 and 3, found on previous page)

Historically, preferred securities have been moderately correlated with common equities and high yield bonds. Importantly, preferreds have not been particularly correlated with 10-year Treasuries, which suggests limited links between their returns and interest rates. (Exhibit 4)

EXHIBIT 4: INCREASED DIVERSIFICATION

PreferredsHigh Yield

BondsS&P 500®

IndexLevered Loans

10-Year Treasury Municipals Corporates

Preferreds 1.00

High Yield Bonds 0.71 1.00

S&P 500® Index 0.59 0.76 1.00

Levered Loans 0.58 0.84 0.63 1.00

10-Year Treasury 0.09 -0.22 -0.40 -0.35 1.00

Corporates 0.71 0.67 0.38 0.56 0.44 1.00

Municipals 0.44 0.35 0.06 0.27 0.54 0.65 1.00

Source: Allianz Global Investors US LLC, ICE BofA Merrill Lynch. Correlation of returns 6/30/2011-6/30/2021 of ICE BofAML Fixed Rate Preferred Securities Index, ICE BofAML US High Yield Master Index, S&P 500® Index, ICE BofAML Current 10YR Index, JP Morgan Leveraged Loans Index, ICE BofAML Current 10-Year Index, ICE BofAML 3-7 US Municipal Securities Index, ICE BofAML US Corporate Index.

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This savings is passed through to individuals who own preferred securities outright and to those who own them through a mutual fund. Individuals receive the qualified dividend tax rate on the dividend income rather than be taxed at their margin tax rate, which can translate into significant tax savings for retail investors with higher marginal tax rates.

In the example to the right (Exhibit 6), a preferred security and a high yield bond start with the same 5.0% pre-tax income stream. Given the differential in tax treatment, the after-tax return for the preferred security ends up higher.

Ratings examples (Moodys/S&P)


EXHIBIT 7: PREFERREDS AND THE CAPITAL STRUCTURE

Priority of claims

Capital structure

Possible equity treatment

Payment format

Typical term

JPMorgan & Company

Bank Chase of America

Highest Senior debt No Non-deferrable interest

Short-long term A3/A- A3/A-

Subordinated debt

No Non-deferrable interest

Medium to long term

Baa1/BBB+ Baa2/BBB+

Junior subordinated debt

Limited Deferrable interest

Long term Baa2/BBB- Baa3/BBB-

Preferred equity securities

Yes Dividend Perpetual Baa3/BBB- Baa1/BBB-

Lowest Common equity Yes Dividend Perpetual N/A N/A

Banks Electric Diversified Financial ServicesInsurance

Other TelecommunicationsREITS

60.65%

2.88%1.48%

9.79%

7.88%

13.07%

4.25%

Source: Allianz Global Investors US LLC As represented by the ICE BofA Fixed Rate Preferred Securities Index.

EXHIBIT 8: INDUSTRY BREAKDOWN OF THE MARKET Preferreds in Issuer Capital StructurePreferreds are a form of equity for issuers. These securities offer an ability to meet capitalization targets, particularly requirements established by regulators or ratings agencies, without diluting existing shareholders’ control and claim on future earnings.

Regulated entities, such as banks, insurance companies, and utilities, represent 75% of the market. This reflects the regulatory requirement for junior capital securities.

Unregulated corporations often issue interest bearing junior subordinated securities classified as debt on their balance sheet but with hybrid equity features similar to preferred equity as they attempt to make an issuer more appealing in the eyes of debt rating agencies rather than regulators. Aside from paying interest rather than dividends, these securities may offer other features of the preferred share class, such as deferrable coupons and long maturities.

Market SegmentationA company can issue securities into either the retail or institutional market. It generally utilizes both to diversify its investor base and tap into the various sources of capital and liquidity available to it. Retail investors are often looking at absolute coupon or yield to call, while institutional investors are usually looking at preferred securities’ comparable spread over senior bonds from the same issuer or over Treasuries.

EXHIBIT 6: PREFERREDS MAY PROVIDE BETTER AFTER-TAX RETURNS

Preferred security High yield security

Par $10,000 $10,000

Coupon/yield 5.00% 5.00%

Annual payment $600 $600

Coupon tax rate 37.0%

Qualified dividend tax rate 20.0%

Net of tax cash flow $480 $378

After-tax yield 4.80% 3.78%

Source: IRS, 2019

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While each market segment has security structures tailored to its primary investor bases, a few securities exist that offer nearly identical credit and structural risk. Differences in technicals and value assessment driven by supply and demand in the two markets can cause substantial differences in the value of similar securities over time. Pricing discrepancies can provide active managers with the ability to move between the markets and capture value while selecting securities that seek to offer the best risk/ return profile for an investment portfolio.

Exhibit 9, to the right, shows how two similar preferred securities issued in different segments of the market can diverge in price over time.

The Case for Active ManagementA variety of security structures within the market allow managers to customize their holdings to create a portfolio with the risk/reward features that suit their strategies.

n Character/issuer treatment – A preferred issue may be characterized as either equity or debt on an issuer’s balance sheet.

n Priority of claims – Preferred securities are junior to the company’s debt and are senior only to common equity. If a company filed for bankruptcy and assets were liquidated, the proceeds would go first to pay off creditors. The most senior creditors would get paid first, and then any remaining proceeds would flow down the waterfall of the capital structure. Recovery rates, the amount received in liquidation as a percentage of par, would be lower the further down the capital the securities are positioned.

n Nature of payment – Distributions of preferred securities could be in the form of interest or dividend payments and paid on either a quarterly or semi-annual basis. The tax characteristics of the payment depends on the jurisdiction of the issuer and investor and may also depend on the specific security structure. Interest payments are tax deductible for the issuer, but usually fully taxable for the investor. Dividend payments are not tax deductible for the issuer, but they may receive beneficial tax rates for the investor.

n Term – A preferred issue may be short- or long-dated, fixed maturity or perpetual.

n Payment deferment option – Most preferred securities have a payment deferral feature; suspending or deferring distributions on preferreds will not trigger a default for creditors.

n Cumulative or noncumulative – Individual security structures will stipulate if any missed payments are cumulative or noncumulative. Missed cumulative payments would need to be paid before dividends could be paid to common shareholders. Noncumulative payments would not be required to be repaid, but preferred distributions would need to be resumed before common dividends could be paid.

n Callable – Most preferred securities are callable or redeemable prior to maturity by the issuer. This provides an issuer the right to buy the security back at par from investors before the maturity date. An issuer would likely exercise this right if interest rates declined, or if its credit spread had tightened dramatically, suggesting it could re-issue securities with lower coupons. This feature creates reinvestment risk for the investor.

EXHIBIT 9: PRICE COMPARISON OF RETAIL AND INSTITUTIONAL PREFERRED SECURITIES

Issue type Retail* Institutional

Par $25 $1000

Coupon 5.85% 5.90%

Payments Noncumulative Noncumulative

Call Date Sep-23 Jun-24

Maturity Perpetual Perpetual

Rating Baa2/BB+ Baa2/BB+

12/31/2019 Retail Institutional

Price 109.6 108.9

Yield-to-Call 3.28 3.74


Price 97.4 98.3



Price 103.6 106.2



Price 110.2 107.8


Source: Bloomberg, Allianz Global Investors US LLC * The price of the retail security has been adjusted to offer a comparison with the institutional security.

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EXHIBIT 10: COMPARING RETAIL and INSTITUTIONAL PREFERREDS

Feature

Senior or Subordinated Notes: Baby

Bonds

Trust Preferred (TRUPs) Hybrid

Traditional Preferred

Stock

Contingent Capital (CoCo)

REIT Preferreds

Common Equity

Character/issuer treatment

Debt Debt Debt Equity Debt Equity Equity

Priority of claims

Senior to TRUPs, hybrids,

preferreds, and common

equity

Senior to hybrids,

preferreds, and common equity; junior to senior and subordinate

debt

Junior to all debt; senior to common equity and preferred

stock

Junior to all debt; senior to common

equity


equity


equity

Junior to all debt and preferreds

Nature of payment

Interest Interest Interest Dividend Interest Dividend Dividend

Paid out of pre-tax/after-tax earnings claims

Pre-tax Pre-tax Pre-tax After-tax Pre-tax After-tax After-tax

U.S. tax treatment

Fully taxable Fully taxableSome

DRD/QDI*Mostly

DRD/QDIFully taxable Fully taxable DRD/QDI

TermDated Fixed

Maturity

Typically 30 yrs original maturity

Typically 60+ yrs original maturity

Typically perpetual

Perpetual Perpetual Perpetual

Payment deferral option

NoneYes, typically

5-10 yrsYes Yes Yes Yes Yes

Cumulative or noncumulative

Cumulative CumulativeCumulative +

NoncumulativeCumulative +

NoncumulativeNoncumulative Cumulative Noncumulative

CallableTypically after

5 yrsTypically after

10 yrsYes, various

Typically after 5 or 10 yrs

Typically after 5 or 10 yrs

Typically after 5 yrs

No

Source: Allianz Global Investors US LLC *DRD—dividend received deduction. QDI—Qualified dividend income.

The Takeaway: Like Golf, Hybrids Offer Versatility

In golf, hybrid clubs can combine the best qualities of fairway woods and long irons and (if swung right) avoid the negatives of both. In investing, preferreds can be considered an income hybrid with the potential to help investors diversify their fixed income portfolios, achieve an attractive return, and manage interest rate risk in a rising rate environment—all in all, a good tool to have in a strategic asset allocation.

To learn more

about the potential

advantages of

preferreds, please

contact us at

800-243-4361

or visit virtus.com

INDEX DEFINITIONSICE BofA Fixed Rate Preferred Securities Index (Credit quality: BBB) tracks the performance of fixed-rate U.S. dollar-denominated preferred securities issued in the U.S. domestic market. ICE BofA Current 10 YR Index is a subset of the Bank of America Treasury Master Index. The index measures the total return performance of U.S. Treasury bonds with an outstanding par that is greater than or equal to $25 million. ICE BofAML 3-7 Year US Municipal Securities Index is a market capitalization-weighted index of investment grade tax-exempt municipal bonds with maturities of 3-7 years. The index is calculated on a total return basis. The ICE BofAML U.S. Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market. The ICE BofA US High Yield Index tracks the performance of below investment grade U.S. dollar denominated corporate bonds publicly issued in the U.S. domestic market and includes issues with a credit rating of BBB or below. The S&P 500® Index is a free-float market-capitalization weighted index of 500 of the largest U.S. companies. The index is calculated on a total return basis with dividends reinvested. The J.P. Morgan Leveraged Loan Index is designed to mirror the investable universe of U.S. dollar institutional leveraged loans, including U.S. and international borrowers. The indexes are unmanaged, their returns do not reflect any fees, expenses, or sales charges, and are not available for direct investment.

GLOSSARYYield to Maturity is the yield to maturity is the percentage of the rate of return for a fixed-rate security should an investor hold onto the asset until maturity. Correlation Coefficient is a measure that determines the degree to which two variables’ movements are associated. The correlation coefficient will vary from -1 to +1. A -1 indicates perfect negative correlation and +1 indicates perfect positive correlation. Qualified Dividend Income: A qualified dividend is a dividend that falls under capital gains tax rates that are lower than the income tax rates on unqualified, or ordinary, dividends.

IMPORTANT RISK CONSIDERATIONSContingent Convertible Securities: Contingent convertible securities (“CoCos”) are subject to greater levels of credit and liquidity risk than fixed income securities generally. They may rank junior to other creditors in the event of a liquidation or other bankruptcy-related event and become further subordinated as a result of conversion from debt to equity. Issuer Risk: The portfolio will be affected by factors specific to the issuers of securities and other instruments in which the portfolio invests, including actual or perceived changes in the financial condition or business prospects of such issuers. Equity Securities: The market price of equity securities may be adversely affected by financial market, industry, or issuer-specific events. Focus on a particular style or on small or medium-sized companies may enhance that risk. Preferred Stocks: Preferred stocks may decline in price, fail to pay dividends, or be illiquid. Debt Instruments: Debt instruments are subject to greater levels of credit and liquidity risk, may be speculative and may decline in value due to changes in interest rates or an issuer’s or counterparty’s deterioration or default. Convertible Securities: A convertible security may be called for redemption at a time and price unfavorable to the portfolio. High Yield Fixed Income Securities: There is a greater risk of issuer default, less liquidity, and increased price volatility related to high yield securities than investment grade securities. Liquidity: Certain securities may be difficult to sell at a time and price beneficial to the portfolio. ABS/MBS: Changes in interest rates can cause both extension and prepayment risks for asset- and mortgage-backed securities. These securities are also subject to risks associated with the non-repayment of underlying collateral, including losses to the portfolio. Foreign Investing: Investing in foreign securities subjects the portfolio to additional risks such as increased volatility, currency fluctuations, less liquidity, and political, regulatory, economic, and market risk. Variable Distribution Risk: Periodic distributions by investments of variable or floating interest rates vary with fluctuations in market interest rates.

RATINGS DISTRIBUTION METHODOLOGYCredit ratings issued by Nationally Recognized Statistical Rating Organizations assess the credit worthiness of the issuers of the underlying securities and not to the Fund or its shares. Ratings are measured using a scale that ranges from AAA (highest) to NR (not rated). Not rated securities do not necessarily indicate low quality. The security’s credit rating does not eliminate risk and credit ratings are subject to change. Credit Quality reflects the middle rating of Standard & Poor’s (S&P), Fitch and Moody’s. If there are only two ratings available, the lower rating of the two will be used. Only one rating will be utilized if only one is available. Ratings are then adjusted to the S&P rating tiers shown.

Please consider a Fund’s investment objectives, risks, charges, and expenses carefully before investing. For this and other information about any Virtus Fund, contact your financial professional, call 800-243-4361, or visit virtus.com for a prospectus or summary prospectus. Read it carefully before investing.

Not insured by FDIC/NCUSIF or any federal government agency. No bank guarantee. Not a deposit. May lose value.Mutual funds distributed by VP Distributors, LLC, member FINRA and subsidiary of Virtus Investment Partners, Inc.5917 7-21 © Virtus Mutual Funds

Preferred Securities: The Overlooked Fixed Income Alternative

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