Portfolio perspectives

Preferred securities: Stocks or bonds?

The low interest rate environment over the past decade-plus led some advisors and portfolio managers to look beyond the traditional bond universe to increase the yields of their fixed income allocations. One category that we identified in our 2023 advisors trend data was preferred stocks, which were present in approximately 13% of the nearly 1,200 fixed income portfolios we analyzed.

Incorporating the characteristics of stocks and bonds

Preferred securities are generally considered a hybrid security, meaning they incorporate both equity and fixed income characteristics. Like common stock, preferred securities represent ownership of a company and can be traded on a stock exchange. And while they typically don’t have voting rights, preferred security holders do have a higher claim to distributions for example, dividends, and in the event of a liquidation, a higher claim to company assets than common stockholders.

Preferred securities also contain some of the attributes we commonly associate with bonds. For example, both securities can be issued at par value and dividend payments are generally regular in the same manner that we expect from interest payments on bonds. Note that not all preferred securities operate in the same way, and some may offer different characteristics than those listed here.

Risk versus reward

Like any investment, preferred securities have their trade-offs between risk and reward, so you should consider what role they might play in diversified investment strategies. For example, preferred securities might deliver higher yields; however, this can come at the expense of higher volatility relative to traditional investment-grade bonds. Considering correlations of monthly returns over the last 20 years, preferred securities had a correlation of 0.5 with the broad U.S. equity market, while bonds had a correlation of 0.22. As Figure 1 shows, the higher correlation between preferred stocks and equities suggests that they don't offer the same diversification benefits to equities as their high-quality fixed income counterparts.

Figure 1: Preferred securities show a higher correlation to stocks than bonds
 

Source: Morningstar Direct, as of April 30, 2024.

Because the role of the fixed income allocation is often to serve as the diversifier to equity risk, another lens we considered was the performance of preferred stocks relative to their investment-grade fixed income and equity counterparts during the worst decile of monthly equity returns over the past 20 years. Figure 2 below captures the distribution and median return for preferred stocks, equities, and the Bloomberg US Aggregate Bond Index during these months. Notably, high-quality fixed income delivered more consistent protection along with substantially lower volatility than preferred stocks when equity markets were at their worst. Thus, if the goal of your fixed income sleeve is to diversify equity risk, even marginal allocations to preferred stocks could produce unexpected drawdowns.