Preferred securities are yielding nearly 7%. After a turbulent first half, here's why it may be time to jump in

Published Thu, Jul 6 202312:15 PM EDTUpdated Thu, Jul 6 20231:19 PM EDT

After a rocky first half of the year, it may be a good time to buy preferred securities. While riskier than Treasurys, investors can get a nearly 7% yield with preferreds. On Thursday, Treasury yields spiked, with the 2-year reaching a level not seen in 16 years after investors worried strong jobs data may spur further tightening from the Federal Reserve. The 10-year also jumped and was last trading at 4.037%. However, preferreds have characteristics of both bonds and equities. They trade on exchanges like stocks but have a face value and pay dividends like bonds. Also similar to bonds, when the value of the preferred security goes down, yields rise. Three-quarters of preferreds are issued by financial institutions and tumbled during the banking crisis. That has also created an opportunity for capital appreciation , experts said. "The financial instability that we saw in March was unexpected and there was a large, broad-based contagion effect," explained Leslie Falconio, head of taxable fixed income strategy at UBS' chief investment office. Michael Youngworth, head of global convertibles and preferreds strategy at BofA Securities, said he sees silver linings to the turbulent landscape. "Relative value opportunities open up," he said. "We're seeing a lot more yield than we've seen in the past." The ICE BofA Fixed Rate Preferred Securities index, which tracks the performance of fixed-rate preferred securities, has a yield-to-worst of 6.7%. That's near a 13-year high, Youngworth said. While volatility remains, the "storm has lifted for now," UBS said in a note last week . The bank upgraded the securities to a "most preferred" position in May, although it said investors should be selective. Longer term, preferreds should benefit when the Federal Reserve stops hiking interest rates and yield on the 10-year Treasury yield starts to decline, UBS' Falconio said. UBS sees the central bank starting to ease in 2024. "You are able to get some very good price appreciation as well as just clipping the coupon because of the large contagion that we saw during that time of financial instability," she said. There is also a tax advantage for preferreds that have qualified dividends, which are taxed as long-term capital gains. Bonds, on the other hand, are generally subject to ordinary income tax, which is higher. While many preferreds have fixed rates, some have floating rates or fixed-to-floating rates that switch from fixed to floating after a certain period of time. History as a guide JR Humphreys, senior portfolio manager with Sheaff Brock Investment Advisors, is also bullish on preferreds. He owns the securities in the funds he manages. This year was supposed to be a great one for preferreds, before the banking crisis hit, he said. Typically, whenever preferred stocks have a negative year, they have a strong performance the following year — with the exception of the financial crisis in 2008 and 2009,Humphreys said. In 2022, the ICE BofA Fixed Rate Preferred Securities index lost 19%. Before that, the benchmark lost 4.3% in 2018. The next year, it gained 17.7%. After 2008′s 25.2% loss, it bounced back 20.1% in 2009 and after 1999′s 4.4% slide, it rallied 16.2% in 2000, Humphrey said. While the index is slowly recovering, there is still time to get capital appreciation, as well as the high yield, he said. "It's a great time to start moving into fixed income," he said. "With preferreds, you get a higher yield than investment grade credit because of where they sit on the balance sheet." Corporate bond debt is paid off before preferred shares in the event of a bankruptcy, which is why preferreds are riskier than bonds. However, buying a good company can help mitigate that risk, Humphreys said. "I'm not looking at a preferred in anticipation of where I will be if they go bankrupt, I don't want to be there. So I look at what the overall senior debt is," he explained. "That tells me more about how the company is." Among those he owns and likes are JPMorgan, American Equity Investment, PacWest and Western Alliance, although he calls the two regional banks "spicy." Do your homework UBS likes more of the larger banks and some of the bigger regional institutions. "We don't want to go too far down the spectrum," Falconio said. Investors should also be aware that preferreds can be very volatile. "You really need to pay attention to risk-adjusted returns when you allocate to this sector," she said. Bank of America's Youngworth also sees opportunity in the larger, safer banks. "If you're going to get involved in regional banks, do your due diligence, do your homework," he said. "You want to make sure that you are in the best companies. And just because the yield is attractive, doesn't necessarily make it a good investment." For those who don't want to research individual securities, there are funds available that invest in preferreds. Bank of America initiated coverage of 11 preferred exchange-traded funds in June. Its top-rated funds include Global X US Preferred ETF and iShares Preferred & Income Securities ETF. — CNBC's Michael Bloom contributed reporting.