US Preferred Securities: Unique Characteristics from a Bramshill Perspective
With interest rates around the world at or approaching all time lows, income investors have an obvious motivation to look beyond their customary areas of market concentration. From its perspective as an unconstrained income investor, Bramshill believes that the U.S. market in preferred securities is quite compelling compared to most alternatives.
Preferred securities have greatly evolved in recent years. From their early origins in this country as a vehicle used primarily to finance growth in utilities, they evolved beginning in the 1980’s to be used primarily by financial firms that found them to be a useful tool for building a capital structure that met their regulatory environment, although they continued to be used by utilities, industrials, REIT’s, and other sectors of the economy. Traditional preferreds were originally conceived as an intermediate form of capital that occupied a position in the capital structure between common stock and debt and received a fixed payment from after tax profits, which could be interrupted only if dividends to common shares were discontinued (but without forcing a default as would be the case for an interruption in debt service). Because dividends on many of these securities are paid from after tax profits, both individuals and certain corporate owners may be allowed to deduct 70% of the income from their income tax, the “Dividend Received Deduction” or DRD.
More recently, a variety of newer structures have been offered which are more nearly like debt than the traditional preferred shares, though they usually are exchange listed and trade in a manner similar to traditional preferreds. These include securities characterized as senior notes, which are effectively bonds; trust and hybrid preferreds, which combine debt and equity; and REIT preferreds for which interest payments are paid from after tax profits but do not receive the DRD privilege due to other tax benefits available to REIT’s. Non-US firms sometimes offer preferred securities denominated in dollars, which are referred to as Yankee preferreds. The total dollar based preferred market is estimated to be approximately $500 billion, and is broken down by type and issuer as shown in Figure 1.
Source: BofA Merrill Lynch Global Research
Although this level of preferred market capitalization makes the sector eminently investable, its modest size relative to $ 4 trillion of US corporate bonds and $ 26 trillion of US equities helps explain why it is sometimes overlooked by income investors.