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Preferreds, What Are They?

It appears there are quite a few products in the bond market that are out of reach for the typical retail investor. Today’s product is the preferred bond. Preferreds are a group of hybrid securities with characteristics of both stocks and bonds. They are fixed-income instruments with equity-like features.

I previously delved into the area of exclusive products in my story “​​Why Would a Public Company Ever Issue Private Bonds?”

Typically sold by banks, insurance companies, and utilities, preferreds are subordinated in a company’s capital structure. Preferreds are junior to a company’s senior debt (bonds) and senior to its common equity (stock). The two main assets in this group are preferred stock and preferred bonds.

Preferreds are great investments for income investors because of their steady income payments However, only preferred stock is available to retail investors. Preferred bonds are usually purchased by mutual fund managers or other institutional investors.

Preferred stock is a perpetual asset with no maturity date that trades on the stock market, like common stock. It pays a fixed-rate quarterly dividend for the life of the asset and can be callable after five years. Preferred stock has a par value of $25 a share.

Preferred bonds trade over-the-counter like corporate bonds. They have a par value of $1,000 and pay semi-annual dividends that have either fixed or floating interest rates. They also have call options typically at five or 10 years.

Preferred bonds typically give better terms and higher yields than preferred equity, but they're difficult for the average investor to buy. The main hurdle is the price. Preferred bonds typically trade at $500,000 or more. This means a preferred bond investor receives both better yields and a better risk-adjusted product than the preferred equity holder.

Institutional investors prefer preferred bonds because they can negotiate better terms as a bondholder. One of those better terms is getting paid a floating interest rate after five to 10 years of fixed coupon. While this feature costs the corporate issuer, it dramatically reduces the interest-rate risk for the bondholder.

Lack of awareness and access to the bond world limits most retail investors to the equity market. Unfortunately, preferred stock tends to underperform preferred bonds during a rising rate environment.

This week’s bond was issued by Zions Bank. Founded in 1873, the bank is based in Salt Lake City, Utah. The Zions Bank has both preferred stocks and preferred bonds.

In November 2021, the preferred stock (ZB.PRH) currently has a dividend yield of 5.58%. The preferred bond (with a bond identifier CUSIP 989701BF3) currently has a yield of 6.625%. Thus, for the same default risk and priority of repayment in a bankruptcy, institutional investors can buy a bond with a higher yield than the stock.

Since the bond’s coupon resets in 2023, it has less than two years of interest-rate risk. On the other hand, the stock has a fixed coupon for life. Therefore, its interest-rate risk is nine times greater than the bond. This is best seen if we calculate what would happen if interest rates were to rise by one percentage point. The preferred stock price would fall 15%, but the preferred bond price would be just 2% lower.

For investors focused on income, preferreds are a great addition to your portfolio. Unfortunately, for most investors preferred bonds are unavailable. We at Arthur are trying to change that and make the bond market more democratic and available to everyone.

If you find this story interesting and want more ideas, analyses, and perspectives on the bond market, please subscribe to our newsletter. We are sending out more stories like this on a weekly basis.

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