A New Rung on the Bond Ladder: Hybrid Preferreds
I received a confirmation for a hybrid-preferred security. What does that mean?
These securities have coupons of around 4%, typically with 5-year call protection — though they have maturity dates going out 30+ years (more on that below). If the security is not called after five years, the coupon adjusts based on a spread above the 5-year treasury rate, or SOFR (secured overnight financing rate, the new LIBOR) and won’t reset for another five years. Current coupon resets are around 3% or so above the 5-year treasury rate in 2025.
We like these for three reasons:
- We are locking in what should be a very competitive yield for the duration of the call protection period.
- The floating rate component is intended to allow the yield to continue to be competitive in the event the security is not called after 4 to 5 years.
- The coupon payments are typically treated as qualified dividend income, so the income is tax advantaged vis a vis a corporate bond.
Of course these advantages result in a unique risk profile versus the corporate and municipal bonds that you own.
- The main risk with these securities is their pricing behavior in a broad market sell off. Unlike the bonds you own, the prices of preferred securities will sell off along with equities, though hopefully to a lesser degree.
- Additionally, since these securities have very long maturity dates, if at all (different from the call protection period), a sudden spike in rates will more adversely affect their price.
- Preferreds sit in between common equity and bonds on the capital structure of a company. In times of stress, a company will first cut the dividend on its common shares, and then its preferred shares, as doing so does not cause a default. Said another way, the preferred coupon payments would be suspended before the interest payments on a bond.
It is possible these securities are never called and thus you own them in perpetuity (unless sold). If rates are appreciably higher in the future, the company is not likely to be able to refinance at lower rates. That said, the floating rate nature of the coupon may make a longer term hold worthwhile in this scenario. It’s also worth noting that our experience with similar securities in the past has been that they are called fairly soon after the protection period ends.
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