As the portfolio manager for the iShares preferred stock ETFs, I spend a lot of time with our sales team and investors, helping them to understand the complexity of these products.
With investors increasingly concerned about a potential rise in interest rates this year, the conversation I’ve been having a lot lately is about how a rate increase might affect preferred stocks, including the iShares S&P US Preferred Stock Index Fund (NYSEArca: PFF).
Before answering the interest rate question, let’s quickly revisit how preferred stocks work.
These are income generating, “hybrid” securities that possess traits found in both equity and debt instruments.
Senior to common stock and subordinate to fixed income in the capital structure, preferreds are usually characterized by higher yield potential and higher risk than bonds, with less opportunity for capital appreciation than common stocks.
Example of a Corporate Capital Structure
Like bonds, preferred stocks are issued at par value and pay “fixed or floating” income (in the form of dividends or interest) based on a percentage of par. Most of them are also assigned a rating by the major credit rating agencies, like Moody’s and S&P. As a result, their prices are sensitive to interest rate changes and credit risk of the issuer.
Many preferreds also have call options embedded in them, meaning the issuer has the right to call or redeem the shares, typically after a lock-up period of five years. Just like a call option in a bond, when the price of the preferred rises above the call price, the issuer may decide to call the security. But the issuer is under no obligation to do so. Instead, issuers tend to look at a range of options when deciding whether or not to redeem shares, including the cost of issuing debt and their overall capital structure.
Next page: Preferred shares and rising rates
So, let’s get back to our question about preferreds and rising rates. There is an inverse relationship between interest rates and the price of preferreds – as interest rates rise, prices are expected to fall. However, the amount of the price change due to a change in interest rates is related to both the term to maturity and the dividend rate paid. In general, the longer the term to maturity, and the lower the dividend rate, the greater the interest rate risk and vice versa. Also, different types of preferred shares do not behave the same way in a changing interest rate environment.
Let’s look at how securities across the preferred spectrum that are held by PFF might perform:
Straight Perpetual Preferreds (45% of PFF)
Compared to all other classes of preferred shares, the perpetual preferreds potentially carry the greatest interest rate risk given that they do not have stated maturity date. Due to their long duration, perpetual preferred shares typically rise in value as credit spreads and interest rates decline. However, the opposite typically happens when the rates increase or when credit spreads widen.
Hybrids and Trust Preferreds (36% of PFF)
Have a stated maturity date and therefore a shorter duration, so relative to perpetual preferred shares they carry lower interest risk. The risk will be related to the individual’s security term to maturity (or duration) and the dividend rate.
Floating Rate Preferreds (13% of PFF)
Relative to other preferred types, floating rate preferreds generally exhibit lower interest rate risk due to the frequent coupon resets that helps to mitigate the price response in a rising rate environment. Floating-rate preferreds offer the potential for higher coupon income as Fed rate increases occur. Since the majority of floating-rate preferreds are tied to short term interest rates, additional Fed tightening will likely lead to higher income distributions.
Convertible Preferreds (6% of PFF)
Convertible preferred stock gives investors the option to convert shares into common stock issued by the same company. The terms of conversion, including the ratio of preferred to common shares involved in the exchange, will be defined at the time of issuance. As a result, these securities are mostly affected by the price of the common stock shares.
So do interest rate changes affect preferreds? Absolutely. Generally, if rates are rising due to strong economic growth, credit risk is declining and riskier assets outperform safer assets. But the thing to remember is that, because they’re hybrid securities, the returns of preferred stocks will be a function of both interest rates and the outlook of the health of the issuer – with the latter likely being the bigger driver. So the price and yield relationship tends to be less direct than a plain vanilla bond.
Although higher interest rates generally correspond with lower prices on preferred shares, tightening of credit spreads could potentially offset the rise in interest rates and reduce the overall impact. Further credit spread tightening could potentially offset some of the anticipated increases in interest rates.
Investors may want to consider preferred stocks as a diversifying investment in their portfolios. Since they act as hybrid securities, they can be another source of yield besides just buying bonds. Just be aware of the drivers of the returns on the securities.
Mariela Jobson is Vice President and portfolio manager in BlackRock’s iShares Index Equity Portfolio Management Group.