Understanding Bank Preferreds

Preferred stock, a kind of hybrid security that has characteristics of both debt and equity, is attracting more interest from investors who are seeking higher yielding investments in the current low interest rate environment. Mainly issued by financial institutions, preferreds have several advantages as well as some risks to be aware of.

The Hunt for Yield

Bank preferreds are usually issued with advertised yields that are well above other high quality income vehicles. While the 10-year Treasury currently has a yield of about 2.9%, many preferreds currently offer yields above 5%.

Supply and demand dynamics are a notable positive for bank preferreds at this time. After the financial crisis of 2008, banks issued a significant amount of preferreds to meet the new higher capital levels required by regulators. Now that many of those needs have been met, issuance has slowed. This has created a very positive technical backdrop for preferreds.

Tax treatment is another major advantage. Most preferreds issue qualified dividends, which are taxed at lower rates (0% to 23.8% depending on an investor’s tax bracket) than traditional corporate bonds (up to 37% currently). This creates a significantly higher taxable equivalent yield: An investor in the top tax bracket must earn 6.43% in a corporate bond to match the after-tax yield of a 5% preferred (the difference between the top income tax rate vs. the long term capital gain rate that applies to qualified dividends).

What Risks Come With Higher Yield?

 “Bank preferreds can be a worthwhile addition to portfolios for investors seeking tax advantaged income, but it’s important that investors understand their intricacies,” says Paul Servidio, an executive director in Morgan Stanley’s Fixed Income Division.

Bank preferreds have higher yields mainly because they sit lower in the bank’s capital structure to other kinds of debt. While preferred stock is senior to common equity on a bank’s balance sheet, it falls below all other creditors, including subordinated or senior unsecured debt. The risk is that in a bank liquidation, preferred shareholders would get little to nothing in recovery. This is known as subordination risk.

Another risk investors need to be aware of is that many preferreds are now trading above their call price. Many of the issues within the more common $25 par structure have no maturity date but are issued with a five-year call provision. If the credit profile of the bank improves or interest rates fall (or both), that security may then trade at a premium. The so-called yield-to-call may be lower than the coupon yield alone.

 “Structurally, preferreds can come with varying degrees of call protection and coupon schedules,” notes Servidio. “It’s important that investors understand what they are buying.” Additionally, the investor may face reinvestment risk if the preferred is called and interest rates are then lower in the market.

The perpetual nature of a preferred also brings interest rate risk, as there is no set maturity date in which the issuer must redeem the security. If longer term interest rates go higher, the price of the security may dip.

Investors who want to mitigate this risk can invest in what are known as fixed-to-floating rate preferreds. These preferreds pay a fixed coupon for a set period of time. Then, if not called, the coupon floats to a fixed spread over Libor, (a benchmark short-term interest rate). Many of these securities have a par value of $1,000 and have traditionally been an institutional only product, but they are increasingly available to individual investors as well.

A final risk worth mentioning: As preferreds mainly pay dividends, not interest, the issuer has the ability to turn off the coupon indefinitely if its capital levels fall dramatically. It is important to note, however, that this can normally only happen if that issuer first eliminates its common dividend (generally not something a bank wants to do), and Morgan Stanley & Co. analysts do not see this as likely given the current strength of the banking sector.

Financial Strength of Banks Is a Plus

In the aftermath of the financial crisis banks were required to significantly bolster their capital positions, creating a much stronger fundamental backdrop in the preferred space.  “The strength of the financial sector now is a big reason we are comfortable suggesting that certain investors can consider moving down the capital structure with bank preferreds,” says Servidio.

While the Federal Reserve hiking short term interest rates could lead to fluctuations in pricing and trading levels, this fundamental strength may mean that there is limited risk that the high coupon payments of preferreds will be disrupted in the near future.

To learn more about preferred securities and how they might fit into your broader portfolio strategy, speak with your Morgan Stanley Financial Advisor (or find a Financial Advisor near you using the locator below).

Important Information:

Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States.

This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or instrument, or to participate in any trading strategy. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Wealth Management or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Information contained herein has been obtained from sources considered to be reliable. Morgan Stanley Smith Barney LLC does not guarantee their accuracy or completeness.

Preferred Products

The majority of $25 and $1000 par preferred securities are “callable” meaning that the issuer may retire the securities at specific prices and dates prior to maturity. [Interest/dividend payments on certain preferred issues may be deferred by the issuer for periods of up to 5 to 10 years, depending on the particular issue. Price quoted is per $25 or $1,000 share, unless otherwise specified. Current yield is calculated by multiplying the coupon by par value divided by the market price.

The initial interest rate on a floating-rate security may be lower than that of a fixed-rate security of the same maturity because investors expect to receive additional income due to future increases in the floating security’s underlying reference rate. The reference rate could be an index or an interest rate. However, there can be no assurance that the reference rate will increase. Some floating-rate securities may be subject to call risk.

Some $25 or $1000 par preferred securities are QDI (Qualified Dividend Income) eligible. Information on QDI eligibility is obtained from third party sources. The dividend income on QDI eligible preferreds qualifies for a reduced tax rate. Many traditional ‘dividend paying’ perpetual preferred securities (traditional preferreds with no maturity date) are QDI eligible. In order to qualify for the preferential tax treatment all qualifying preferred securities must be held by investors for a minimum period – 91 days during a 180 day window period, beginning 90 days before the ex-dividend date.

Risk Considerations

Credit Risk The possibility that the issuer might be unable to pay distributions and/or principal on a timely basis is known as credit risk. The rating agencies, such as Moody’s, Standard & Poor’s and Fitch Ratings evaluate quantitative and qualitative factors to determine a credit rating, which is a measure of an issuer’s creditworthiness.

Call Risk The majority of preferred securities are callable, allowing the issuer to redeem them prior to maturity. If the security is called, the investor bears the risk of reinvesting the proceeds at a potentially lower rate of return. To compensate investors for the issuer’s early redemption option, callable preferred securities typically offer the following: higher yields than their non-callable counterparts; a call protection period (usually five years from issuance) during which time the issuer cannot redeem the securities; and, in certain cases, a call premium, where the issuer pays the holder of a called security a price greater than their par value. Preferred securities generally have call provisions allowing the issuer to redeem them prior to their stated call date, provided a capital treatment, tax or regulatory event occurs, and if regulatory approval is received.

Interest Rate and Duration Risk The possibility that the market value of securities might rise or fall due to changes in prevailing interest rates is known as interest rate risk. Fixed income securities are susceptible to fluctuations in interest rates; all else being equal, if interest rates rise, preferred prices will generally fall, and vice versa. Duration is a measure of a bond’s price sensitivity to changes in interest rates. The higher the bond’s duration, the more sensitive its market value is to changes in interest rates. Your Financial Advisor can provide you with the duration on your fixed income securities.

Secondary Market Risk Many preferreds are listed on securities exchanges, which may provide a higher degree of transparency. However, there is no guarantee that an active or liquid secondary market will exist for any individual issue. If a security is sold in the secondary market prior to maturity (or call date), the price received may be more or less than the face value or the original purchase price, depending on market conditions at the time of the sale. Prices can be volatile during periods of market turbulence, and some preferred issues will be more liquid than others.

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.

Credit ratings are subject to change.

Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors do not provide legal or tax advice. Each client should always consult his/her personal tax and/or legal advisor for information concerning his/her individual situation and to learn about any potential tax or other implications that may result from acting on a particular recommendation including but not limited to matters involving taxation and tax planning, trust and estate planning, charitable giving, 529 plans, and philanthropic planning.

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