Preferred equities are finally reasonably priced and this asset class has also become appealing in other ways. There are three reasons right now to consider adding them to your investment portfolio: the lower price, modest risk and technical support for the price going forward. Of course, there are also reasons to be cautious, as you should be with any type of security. Here’s what you need to know.
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What Are Preferred Equities?
Preferred equities or stock are shares in a company that carry some bond-like features. They are typically long-dated securities with call protection, and the most common type of preferred equities is issued by commercial banks. Like common stock, this asset class can provide capital appreciation, but it generally comes with a fixed dividend rate. Dividends to preferred shareholders are paid before dividends to common shareholders. Another difference is that if the company that issued the shares is liquidated, preferred stockholders will have access to the company’s assets before common stockholders, though they will be behind bondholders.
Because you lock in your rate of return when you buy preferred equities you won’t gain from company growth in the form of higher dividends like a common stockholder could. Your dividends could be deferred if the company can’t afford to pay shareholders. Plus, you don’t have voting rights as a preferred shareholder the way you would if you owned common stock. The good news is that the income that preferred equities pay U.S. investors is typically taxed at qualified dividend rates, which are less onerous than ordinary income rates.
Three Reasons to Consider Preferred Equities
Stocks have taken a beating in the first half of 2022, with the S&P 500 falling more than 20% into bear market territory. By midyear inflation was running at more than 9%, and the Federal Reserve was raising the federal funds rate dramatically and lightening its balance sheet to battle inflation. The bond market is anticipating more such aggressive moves, resulting in a yield curve moved to its most inverted level since 2000. The only good thing about bear markets is that they eventually provide attractive entry points for risk assets. Right now, JP Morgan thinks there is an attractive entry point in preferred equities for three reasons:
Valuations Have Risen
A common way of valuing preferred equities is to compare the difference between their yield and the yield on risk-free rates. When the spread is wider, markets are more skeptical about actually receiving future cash flows. “Right now, with all-in yields over 7% and spreads over 400 basis points, we think investors are being compensated fairly for the risk that preferred dividends stop getting paid,” the bank said in a recent article. In the other two periods over the last 10 years when spreads rose above 400 basis points, the median 12-month forward return was over 20%.
Risks Are Modest
Unlike the issuers of high-yield bonds, companies that offer preferred equities tend to be investment-grade with strong balance sheets. Barring a severe recession or Fed mandate, it is highly unlikely that banks will stop issuing common stock dividend payments. And if that did happen it would happen before preferred dividends would be at risk.
Prospects Look Favorable
The limited amount of preferred equities that have been issued so far in 2022 offers technical support to this asset class. While in all of 2021 total issuance of preferred stock was approximately $45 billion, less than $10 billion had been issued by midyear 2022. The law of supply and demand augurs strong price support for preferred stock.
Three Cautionary Notes
JP Morgan cautions, however, that “preferred equities could continue to fall if the economic environment deteriorates beyond the mild recession that seems to be reflected in current prices or if equity and high-yield market volatility remains elevated.”
In addition, this asset class has features that some investors may find unappealing. If interest rates rise, the value of preferred stock falls, just as with bonds. That’s because the opportunity cost of holding that preferred stock is higher once interest rates rise.
Finally, investors should be aware that many preferred shares are “callable.” A callable preferred stock is one that gives the company issuing the stock the option to “call” (revoke) the stock from the shareholder. A call provision usually kicks in after five years. It means that the issuer has the right to buy back your shares at face value. That leaves owners of callable preferred stock vulnerable to the whims of the stock issuer, who may wish to call the stock just when the shareholder would want to hang on to it.
Bottom Line
Preferred equities are being described by some experts as “diamonds in the rough,” especially with current pessimism about the market’s prospects that have hammered prices. But generally this type of security offers steady returns, tax advantages and higher yields. Aside from these benefits, some preferred stock shares may also be convertible, meaning you can convert them to shares of common stock. That could make sense if you want to benefit from rising share prices. If you buy shares of preferred stock at one price and the common stock share price rises, you could convert some or all of your preferred shares to realize a capital gain.
Tips on Investing
- Picking a reasonably priced security can be a challenge. That’s where the expertise and guidance of a financial advisor can be so valuable. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use our no-cost investment calculator to get a quick estimate of how you are doing in reaching your financial goals.
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