Preferred Market Overview

A preferred security is a creature of both equity and debt. It ranks in between a bond and common stock, typically is either perpetual or has very long maturities and, yet, it pays dividend or interest amounts which are fixed according to the terms of the issue and it does not directly participate in the growth or profitability of the company.

Because of these equity features and its longer duration, a preferred security will yield higher than a bond of the same issuer. In fact, because of the generally higher credit quality of preferred securities issuers, preferred securities represent the highest-yielding investment grade asset class.

Tax Characteristics

While heterogeneous, the preferred securities market can be split into two basic categories based on the tax treatment of the security:

  • Traditional preferred securities which generally has a tax advantage for its investors
  • Fully-taxable preferred securities

Tax-advantaged preferred securities can be eligible for either the inter-corporate dividends received deduction (DRD) for corporate taxpayers or qualified dividend income (QDI) treatment for individuals. Similar to how it treats its common shareholders, the issuer of tax-advantaged preferred securities pays dividends to its preferred shareholders out of its after-tax income and consequently cannot deduct those payments.

Fully-taxable preferred securities are equivalent to a subordinated debt obligation of the company and consequently the dividends or interest received on those securities are taxed as ordinary income to the holders. From the issuer’s perspective, it pays dividends or interest to its preferred security holder out of its pre-tax income and deducts those interest payments.

Income Characteristics

Preferred securities pay dividends or interest at either a fixed-rate or a variable rate determined either by formula or through a Dutch auction process. Because of the ranking of preferred securities, an issuer may not pay income to its common shareholders without first paying all its current obligations to holders of its preferred securities. In some circumstances, the issuer may, however, pay its debt holders without paying anything to its preferred holders.

Dividends and interest payments can be either cumulative or non-cumulative. If cumulative, all dividends or interest payments that have not been paid will accumulate and must be paid before holders of common stock receive any dividends. If non-cumulative, the company may elect not to pay a particular periodic dividend without any further obligation to repay that dividend.

In certain instances, failure to pay preferred dividends may entitle preferred shareholders to representation on the company’s board of directors.

Credit Characteristics

In the event of liquidation, preferred shareholders must be paid all dividends and principal before distributions may be made to common shareholders. Many preferred securities are listed on the major stock exchanges, and specialized trading departments of several investment brokerage firms further enhance liquidity.

Some preferred securities may be convertible into the common stock of the issuing corporation.

Returns from investment grade preferred securities correlate much more closely with investment grade bonds and U.S. Treasury securities than with common stocks or "junk" bonds. Preferred portfolios managed by Flaherty and Crumrine have typically averaged low "A" to high "Baa" by the rating services, although we often have authority to invest a portion of the portfolio in below investment grade rated securities.