Understanding Preferred Equities: The Overlooked Asset Class
In the world of investments, preferred equities often get overshadowed by their more popular cousins: common stocks and bonds. However, this hybrid asset class deserves more attention, especially for income-focused investors seeking tax advantages and relative stability. Unlike common stocks or traditional bonds, preferred equities offer a unique combination of features that make them particularly attractive in certain market conditions and for specific investor needs.
Preferred equities are primarily issued by public companies that care deeply about their credit ratings. This creates an alignment between management and preferred shareholders that doesn’t always exist with other investments. Companies will often go to great lengths—including issuing more equity or selling assets—to maintain their targeted credit ratings. This commitment translates to greater security for preferred equity holders, who enjoy priority over common shareholders when it comes to dividend payments. During the pandemic, for instance, we saw hundreds of companies cut common stock dividends, but preferred dividends remained largely intact. This demonstrates the superior position preferred equities hold in the capital stack.
One of the most compelling advantages of preferred equities lies in their tax treatment. Unlike bond interest, which is fully taxable as ordinary income, preferred dividends often qualify for more favorable tax treatment. Many preferred dividends are classified as qualified dividends, meaning they’re taxed at the long-term capital gains rate—potentially as low as 0% for some investors and capped at 20% for high-income earners. Compare this to bond interest, which can be taxed at ordinary income rates up to 37%. Additionally, preferred shareholders can sometimes benefit from excess depreciation benefits and other tax advantages that are never available with bonds. This tax efficiency means that a preferred equity yielding 7-9% could provide significantly better after-tax returns than a bond with a similar pre-tax yield.
The credit quality of preferred equities represents another interesting consideration. Rating agencies tend to penalize preferreds more harshly than they do bonds from the same issuer, focusing heavily on recovery rates in case of default rather than the probability of default itself. This creates an opportunity for savvy investors, as investment-grade companies with strong fundamentals might have their preferred securities rated below investment grade, offering yields that don’t accurately reflect their true risk. With historical default rates for preferreds around 0.6% annually (compared to about 3% for high-yield bonds), the risk-reward profile becomes particularly attractive.
For retirees and income-focused investors, preferred equities can play a strategic role in portfolio construction. By using the steady income from preferreds to cover essential expenses, investors gain the freedom to take more strategic risks with the remainder of their portfolio. This “barbell approach” can potentially enhance overall returns while reducing the stress of market volatility. When the market takes a significant downturn, investors with steady preferred income won’t be forced to liquidate their growth investments at inopportune times, allowing them to weather market storms more comfortably.
Active management appears particularly valuable in the preferred equity space. Unlike with common stocks, where passive index funds often perform competitively, preferreds have unique characteristics that benefit from hands-on management. Most notably, preferreds are typically callable at par (usually $25), which creates risks that passive strategies struggle to manage. When preferreds trade above par, active managers can sell them and recycle capital into more attractive opportunities. Meanwhile, index funds often end up buying overvalued preferreds during rebalancing periods, creating opportunities for active managers to capitalize on. This dynamic, along with the need to manage interest rate risk, credit risk, and call risk, makes a strong case for active management in this asset class rather than simply tracking an index.