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Understanding Preferreds and Capital Securities

Preferreds and capital securities are fixed-income investments with equity-like features mainly issued by large banks and insurance companies.

What are preferred securities?

Traditional preferred and capital securities (also known as “preferreds” or “hybrids”) share the characteristics of both stocks and bonds and may offer investors higher yields than common stock or corporate bonds. Understanding preferreds and capital securities is an important first step in determining if they are an appropriate investment.

These securities are perpetual and callable, typically pay dividends instead of coupons, offer multiple rate structures, often have investment-grade ratings, and are subordinated in the capital structure, as explained below.

  • Perpetual and Callable: Traditional preferreds are issued as perpetuals, i.e. with no stated maturity, but have call options typically at 5 or 10 years.
  • Dividends, Not Coupons: Traditional preferreds pay dividends rather than coupons and in periods of severe stress the issuer may skip a payment without triggering a default. Income earned from preferreds can be taxed at a federal rate, which historically has been considerably less than ordinary income tax rates that are applied to other fixed income securities.
  • Different Rate Structures: Preferreds that have more debt-like traits can have fixed rate, floating rate, or fixed-to-floating rate dividends. Floating rate structures offer significantly less interest rate risk than fixed-rate bonds.
  • Junior Ranking in the Capital Structure: Preferreds rank lower than senior debt and higher than common equity. That means, in the event of an issuer’s default, investors holding that company’s preferreds will get paid back after the bondholders and before the stockholders.
  • Higher Quality Ratings: Preferreds are often issued by investment-grade entities and even though they are typically ranked two or more notches below an issuer’s senior debt, many preferreds still garner investment-grade ratings.

There are two common types of traditional preferred securities – retail and institutional:

Figure 1:

The graphic shows two boxes comparing the two common types of traditional preferred securities, retail and institutional. The section on the left is titled Retail Preferred ($25 par value) and has four bullets: bullet 1 reads, Traded on stock exchange; bullet 2 reads Mostly fixed rate for life; bullet 3 reads Typically callable in 5 years; and bullet 4 reads Pay quarterly dividends. The section on the right is titled Institutional Preferred ($1000 par value) and has four bullets: bullet 1 reads Traded over the counter; bullet 2 reads Mostly fixed-to-floating rate; bullet 3 reads Typically callable in 5 to 10 years; and bullet 4 reads Pay semi-annual dividends.

What are the other types of preferreds?

The global preferred and capital securities market, which was over $1.3 trillion as of 30 June 2024, also includes Additional Tier 1 (AT1) securities, which differ from “traditional” preferreds in a few ways:

  • Preferreds and AT1s all sit above common equity in the capital structure but below senior debt and are meant to absorb losses before senior debtors. In order to absorb losses, preferreds can be converted from debt to equity or their par value can be written down based on regulator discretion but AT1s explicitly state the capital level that would trigger a write-down or conversion.
  • Preferreds dividends, like equity dividends, are discretionary in nature and not mandatory. For issuers of traditional preferreds to defer dividend payments, they must also stop their common dividend while issuers of AT1s have full discretion to stop paying dividends regardless of the common dividend.

The chart below shows the different types of preferred securities and their key features.

Figure 2: Features of Different Types of Preferred Securities (EU AT1s and US Preferreds)

The chart shows the different types of preferred securities and their key features. The table has six columns and five rows. The columns show the different types of preferred securities and the rows shows the features for each type of preferred security. From left, the table shows the features on Column 1, namely Maturity, Coupon Deferral, Regulatory Capital, Contractual Conversion, and Typical Rating. This is followed by Column 2, Senior Debt, which has short- to long-term Maturity, no Coupon Deferral, Inclusion for TLAC, not capital, however under Regulatory Capital, no Contractual Conversion, and A-/A+ Typical Rating. Column 3, Tier 2/Subordinated Debt shows Intermediate to long-term Maturity, no Coupon Deferral, Yes on Regulatory Capital, no Contractual Conversion, and BBB/BBB+ Typical Rating. Column 4, EU AT1 shows Perpetual with call date after 5-10 years Maturity, Yes, fully discretionary Coupon Deferral, Yes on Regulatory Capital, Yes, explicit at 5.125% or 7% capital ratio, and BB+/BBB- Typical Rating. Column 5, U.S. Preferreds shows Perpetual with call date after 5-10 years, Yes, at discretion of board or regulator, but subject to stopping common dividend, yes on Regulatory Capital, Not contractual, regulator discretion for Contractual Conversion, with BBB-/BBB for Typical Rating. Lastly, Column 6, Common Equity, shows Perpetual Maturity, Discretionary Dividend, Yes on Regulatory Capital, N.A. on Contractual Conversion, and N.A. on Typical Rating.
Source: PIMCO, company filings

Why do companies issue preferreds and capital securities?

Preferreds and capital securities are issued primarily by banks and insurance companies. Real estate investment trusts (REITs), utilities, and other financial institutions also issue preferreds. Preferreds and capital securities count toward regulatory capital requirements so banks issue these types of instruments to help them maintain their required capital ratios. These securities can also offer issuers structural benefits, lower capital costs, and improved agency ratings.

Why invest in preferreds and capital securities?

Preferreds and capital securities are attractive because they can provide investors with the potential for attractive risk-adjusted returns, a relatively high source of income, diversification from core bonds, reduced portfolio volatility, lower risk of default, reduced interest rate risk, and certain tax advantages. We expand on these key benefits below:

  • Attractive Risk/Return Profile: Preferreds and capital securities offer an attractive combination of relatively low interest rate risk and relatively high yields/income potential compared to traditional fixed income. Their higher income potential derives from their hybrid nature, combining equity and debt-like features, as described above. Preferreds and capital securities are typically higher quality than high yield bonds – particularly U.S. preferreds, which on average are rated investment-grade – while still offering solid return potential.
  • Diversification Benefits: A dedicated allocation to actively managed preferreds and capital securities can help reduce interest-rate risk and enhance return when used to diversify from core bonds or reduce volatility while enhancing income potential when used to diversify from equity.
  • Lower Default Risk: A significant proportion of preferreds and capital securities issued by banks and the banking sector historically has a lower default rate than other sectors. From 1970 to 2023, the default rate of the banking sector averaged 0.6% while all other sectors averaged 2.2% (Source: Moody’s). Banking sector fundamentals have been improving for more than a decade, as institutions have been restructuring, de-risking and de-leveraging, leading to significantly improved capital ratios.
  • Tax Advantages: Preferred dividends are taxed at qualified dividend income (QDI) rates, at roughly 20%, are considerably less than ordinary income tax rates (top federal rate of 40.8%). This means that for U.S. investors, preferred stocks may provide a compelling after-tax yield relative to other asset classes.
  • Reduced Interest Rate Risk: Many preferreds and capital securities can reduce the interest rate risk in a diversified portfolio given their potential to be called by the issuer and/or become floating rate securities. With relatively high starting yields, these types of securities may be used as a substitute for equities or high yield bonds.

What are the risks?

Similar to other fixed income investments, preferreds and capital securities’ performance can be affected by interest rates and credit risks.  Because these instruments have direct exposure to the overall health of the banking/financial system, returns could be relatively volatile in the event of a shock to the financial markets. Preferreds and capital securities also contain risks that traditional bonds do not, including coupon deferral risk, conversion risk, and write-down risk.

Glossary

  • Additional Tier 1 (“AT1”): AT1s are subordinated debt that are written down or converted into equity in order to absorb losses when explicit capital requirements of the issuer are breached.
  • Dividends Received Deduction (DRD): A tax provision that allows certain corporations to deduct from taxable income 50% of the dividends received on certain preferred and other equity securities. Preferreds whose payments qualify for this treatment are called DRDs. Most domestic non-REIT perpetual preferreds are DRDs.
  • Fixed Rate: Fixed rate securities have a set interest rate which does not fluctuate for its entire term but are typically callable after 5 or 10 years.
  • Fixed-to-Floating Rate: Fixed-to-floating rate securities are typically callable after 5 or 10 years, but their coupon will become floating rate if the security is not called by the issuer. They reset to floating rates at a spread over a short term borrowing rate like SOFR resulting in lower price sensitivity to changes in interest rates.
  • Floating Rate: Floating rate securities offer a dividend or coupon that is reset at specified intervals according to a predetermined formula.
  • Perpetual: Perpetual securities have no stated maturity date and remain outstanding unless called.
  • Qualified Dividend Income (QDI): QDI income is considered dividends for federal tax purposes. U.S. taxpayers who are invested in a QDI-eligible security for more than 90 days during the 121-day period beginning 90 days before the ex-dividend payment face a maximum statutory tax rate of 20% on the dividend. The Medicare surtax imposes an additional 3.8% tax on both interest and dividend income for high income individuals, making the top effective rate 23.8%.
  • Regulatory Capital: Regulatory capital is the amount a bank or other financial institution is required by its financial regulations to hold. This requirement is commonly expressed as a bank capital ratio, calculated by dividing a bank’s regulatory capital by its risk-weighted assets.

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