Can Preferred Securities Help Increase Investors' After-Tax Income?

By JR Humpheys, CFA, CAIA, Senior Portfolio Manager, Innovative Portfolios

Investors seeking income often turn to traditional securities such as dividend-paying stock, bonds—both corporate and municipal, or even high-yield bonds. Preferred equity is often overlooked, yet this unique asset class offers several benefits worth considering. 

Preferred securities do not fit neatly into the traditional asset allocation framework due to their stock- and bond-like features. For the issuer of preferred securities, the securities can be classified as debt or equity on the balance sheet, depending on its features. Generally speaking, preferred securities are considered equity by the issuer, especially financial institutions which utilize preferred securities to meet regulatory capital requirements. If the preferred security is categorized as equity, then the payments made to investors are considered dividends. Preferred securities are considered a fixed income asset from the investor's perspective because they pay a fixed dividend and typically have a call date. 

Attractive Yields

For investors, there are several potential benefits from adding preferred securities to their portfolios. The first is attractive yields versus other fixed income securities. Because of their subordination risk, preferred securities yield more than the senior debt of the issuer. Preferreds currently offer more income than equities and most fixed-income asset classes (as of 05/31/24). 

Data source: Bloomberg as of 4/30/24. Chart shows yield-to-worst for applicable tax rates. After tax-calculation shown use 37% ordinary income tax rate and 3.8% Medicare surtax for high yield bonds, intermediate bonds, and broad bonds. For preferred and US stock, after-tax calculation assumes all income QDI-eligible and taxed at 20% QDI tax rate and 3.8% Medicare surtax. Municipal bond income is not subject to income tax. Indexes used; preferred ICE: BofA Fixed Rate Preferred Securities Index; high-yield bonds: Ice BofA US High Yield Index; municipal bonds: ICE US Broad Municipal Index; intermediate corporate bonds: Bloomberg Intermediate

Potential Tax-Advantaged Income 

Unlike interest income that is taxed as ordinary income, the equity characteristic of most preferred securities generates qualified dividend income (QDI). Ordinary income is taxed at rates ranging between 10%-37% versus qualified dividend income that is taxed at the maximum rate of 20% for 2024. This might generate significant tax savings and after-tax returns regardless of an investor's tax bracket.  

Portfolio Diversification

Due to the hybrid nature of preferred securities, they exhibit relatively low correlation to traditional equity and fixed income investments. Adding preferred securities to a traditional stock/bond portfolio may increase the risk-adjusted return by improving the overall diversification. Preferreds may make sense for an investor with an all-equity portfolio who wants to lower risk but doesn't want to move into corporate bonds due to their low after-tax return. On the other side, an investor with a municipal bond portfolio looking for greater returns who doesn't want the risk from stocks could add preferred securities to their portfolio to potentially generate higher after-tax returns. 

Best Way To Invest In Preferred Securities

Unlike U.S. large cap stocks, the preferred securities market is smaller, the securities are not uniform in structure, and many tend to be illiquid. Information on preferred securities for the average investor is hard to come by. For these reasons, it is perhaps best to use an actively managed ETF or mutual fund. The largest preferred ETFs are passively managed index products that have inefficiencies that can be exploited by active management, such as: call risk, credit quality and concentration risk. 

For investors looking to increase their after-tax income while diversifying their portfolio, the often-overlooked preferred securities asset class might be the answer. 

Featured photo by Dan Meyers on Unsplash.

This post contains sponsored content. This content is for informational purposes only and is not intended to be investing advice.

Disclosure

Benzinga has received cash compensation from Sheaff Brock investment Advisors, LLC (Sheaff Brock) or Innovative Portfolios for the above endorsement. The compensation received by Benzinga is to author an article to endorse Sheaff Brock or Innovative Portfolios, its affiliate. Benzinga is not a current client of Sheaff Brock or Innovative Portfolios. There is a conflict of interest since Benzinga is receiving compensation to recommend either Sheaff Brock or Innovative Portfolios for investment advisory services. The material terms of this compensation are as follows: sponsored articles, videos, webinar, and metrics dashboard for $25,500. There is a conflict of interest in that Benzinga is being paid to endorse either Sheaff Brock or Innovative Portfolios, which would incentivize them to endorse Sheaff Brock or Innovative Portfolios over other advisers.

Past Performance is no guarantee of future results. The information presented above does not reflect the performance of any fund or account managed by Sheaff Brock or Innovative Portfolios and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend will begin. There is no guarantee that any market forecasts set forth in the presentation will be realized. An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses, or taxes. Preferred securities present various risks including interest rate risk, credit risk, call risk, prepayment and extension risk, convertible securities risk, and liquidity risk. The views and opinions are as of the date of publication and are subject to change without notice.

Edward “JR” Humphreys is a senior Portfolio Manager at Sheaff Brock Investment Advisors and its institutional arm, Innovative Portfolios, LLC. The companies mentioned in this publication may be held by Sheaff Brock or Innovative Portfolios, or related persons. Therefore, there may be a conflict of interest in that advisors may have a vested interest in these companies and statements about them.