The coupon of a floating-rate preferred includes two parts: a rate that represents a fixed spread over Treasuries plus a rate that’s allowed to change (or “float”), such as the three-month LIBOR. One reason some investors expect floating-rate preferreds to outperform traditional fixed-rate preferreds in a rising-rate environment is that they tend to trade on a yield-to-call basis — in other words, they trade as if the security will be redeemed on its call date before it matures. By definition, a call date is earlier than a maturity date, so when a security trades on a yield-to-call basis, it trades as though it has a shorter maturity. As a result, it can exhibit less interest rate sensitivity than it would otherwise.
While most of the fixed-rate market is able to be called before it reaches maturity, the majority of it has been issued since 2009 in an exceptionally low interest rate environment. This puts downward pressure on the likelihood of these being called when rates are expected to be higher, which means they tend to trade more on a current yield or yield-to-maturity basis.
By comparison, a fixed-to-floating rate preferred is issued with a fixed-rate coupon that is scheduled to float at some future date when it also becomes callable. The terms of fixed-to-floating preferred stipulate that one of two things will happen on its call date:
- It will be called.
- It will remain outstanding, and its coupon will begin to float.
Regardless of which event occurs, the call date effectively marks the elimination of the preferred’s interest rate risk.
If you’re looking for income with lower interest rate risk than traditional preferred stock, you may want to consider the PowerShares Variable Rate Preferred Portfolio (VRP), an exchange-traded fund that offers exposure solely to variable-rate preferred securities.
1 Source: Morningstar, as of Sept. 30, 2014
2 Source: Bloomberg L.P., Oct. 31, 2014