Preferred shares: a new income opportunity

If you want to enhance your portfolio’s income, you may think it’s a simple question of which bonds to choose. You could select between investment grade credit, high yield bonds and emerging market debt, depending on how much risk you’re able to take.

There is, however, another choice that is often overlooked. Preferred shares offer yields close to those of high yield issuers, but they’re typically from more well-known companies with investment grade credit ratings. 

 

Where can you find 5% yield?

Source: Bloomberg, BofA Merrill Lynch, as at 24 Aug 2017. Past performance is not a reliable indicator of future returns.

 

What are preferred shares?

Preferred shares are hybrid securities. They’re technically equities but have certain characteristics that make them behave more like bonds.  

  • Issued with fixed dividends
  • Preferential treatment of dividends
  • Stated maturity date1

They are subordinate to a company’s debt instruments, so companies attract investors by paying a higher dividend rate than they pay on their bonds.

The majority of issuers are large banks and other financial institutions. REITs and utilities are also well-represented in preferred share indices. The market in the US is estimated at $180 billion.2

 

Key risks to consider

  • No capital protection; you may not get back the amount you invested
  • Changes in interest rates and exchange rates may affect returns
  • Debt-like instruments are exposed to credit risk

 

What drives preferred share yields?

The higher yields (and lower ratings) of preferred shares are due to their subordination to senior debt rather than the quality of the underlying issuer. The following table shows the different securities issued by J.P. Morgan. Even though they are all from the same underlying company, you can see the yield on their preferred shares is considerably higher than other debt securities. 

Example: J.P. Morgan

Data: Bloomberg, 21 Sep 2017

 

There are also diversification benefits

As well as offering high yields, preferred shares offer you other benefits. For instance, they are lowly correlated to other asset classes. This means you can diversify the risk in your equity and bond portfolios by including a holding in preferred shares. 

Data: Bloomberg, correlations based on daily return data from 31 Aug 2012 – 31 Aug 2017. Preferred Shares: BofAML Diversified Core Plus Fixed Rate Preferred Securities Total Return. US Investment Grade: BofAML US Corporate Index. US High Yield: BofAML US High Yield Master II. EM Bonds: BofAML Emerging Markets Diversified Corporate Bond Index Past performance is not a reliable indicator of future returns. 

 

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1 Often issued as perpetual instruments but typically callable, often anytime after five years

2 Source: BofA Merrill Lynch, as at 31 Aug 2017

 

Your capital is at risk. You may not get back the amount you invested.

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