What are active preferred securities ETFs?

Preferred securities can play a supporting role in portfolios for investors looking for attractive income, diversification, and some protection against rising interest rates. An active approach to preferred securities that takes a broader view than index-linked ETFs may make sense for investors seeking potential outperformance and the asset class’s full opportunity set.

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What are preferred securities?

Preferred securities possess attributes of both fixed income and equity. They generally offer higher yields than senior bonds from the same issuer, as preferreds are subordinated in the capital structure. While preferreds have long-term maturities, the issuer can typically call the security 5 or 10 years after the issuance. There are a wide range of types, including preferred securities, hybrids, and preferred stock.

Specifically, preferred securities are a class of stock or hybrid debt entitling the investor to certain preferential treatment. Preferred investors have priority claims to payment of dividends and in the liquidation of company assets over the issuer’s common shareholders. Globally, the size of the preferred securities market is over $1 trillion.¹

Preferred security issuers are mainly large and highly regulated institutions, including banks, insurance companies, utilities and energy infrastructure, and telecom, as well as some consumer sectors.

In terms of where preferred securities typically sit in a company’s capital structure, they’re between traditional bonds and common equity, which is why they’re often thought of as hybrid securities. Although preferreds have higher yields and sit lower on the capital structure than traditional bonds, they’re typically issued by companies with solid balance sheets and investment-grade ratings.

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Source: Manulife Investment Management, as of 11/30/21. A capital structure refers to the way a corporation finances its assets by issuing different types of equity, debt, or hybrid securities. With cumulative preferred securities, dividend payments will accrue in the event the issuer does not make timely dividend payments. These accrued dividends are paid before payment of common stock dividends. For illustrative purposes only.
 

A closer look at preferred securities

Some preferreds have equity-like characteristics such as paying quarterly dividends, while others have debt characteristics since they make semiannual interest payments like corporate bonds.

There are subtle differences between the various types of preferred securities. In our own research, we break the overall preferred market into four main categories:

  1. Retail preferreds: $25 par value, exchange-listed, typically fixed rate, and typically offer higher yields
  2. Convertible preferreds: can be converted from debt to equity, typically in three years
  3. Baby bonds: also known as senior notes, issued with par value less than $1,000, more senior in the capital structure
  4. $1,000 par institutional preferreds: also known as capital securities typically traded over the counter, typically fixed-to-floating rate, and usually have lower volatility than retail preferreds

Most index-linked ETFs for preferred securities tend to focus only on retail preferred and baby bonds, leaving out the full opportunity set that also includes convertible preferreds and the $1,000 par institutional segment.

Why invest in preferred securities?

Yield has always been a big reason to invest in preferred securities, and we’re still in a low interest-rate environment. According to Bloomberg, as of December 31, 2021, the ICE BofA U.S. All Capital Securities Index had a yield of 5.05%.

Another attraction of preferred securities is that they may not be as sensitive to rising interest rates compared to other types of fixed-income sectors. This is because some preferred securities have a floating-rate coupon structure, which rises along with interest rates.

Also, preferred securities offer attractive yield even though most of the issuers are rated investment grade, which is important for credit risk. Finally, diversification is another consideration because these hybrid securities may perform differently than other types of stocks and bonds.

Our outlook for preferred securities

We have a positive outlook on preferred securities for several reasons. First, although the U.S. Federal Reserve recently signaled it’s worried about inflation and may taper faster than expected, overall fiscal and monetary policy remains supportive.

Also, the economy continues to recover after the pandemic-induced recession. And staying on the macroeconomic picture, we don’t think inflation will remain elevated at current levels. We’re in the lower-for-longer camp on interest rates, and U.S. rates are attractive when viewed globally. Credit spreads have widened recently, but we don’t see signs of credit stress in the markets.

As mentioned, preferred securities are usually issued by companies with strong balance sheets, particularly in the financial services and utilities sectors. We believe the fundamentals for both sectors are solid. Banks have benefited from rising interest rates and have strong balance sheets, while utilities are benefiting from investment in renewable energy.

 

Manulife Investment Management, Bloomberg, as of 9/30/21.