2023-07-05 08:50:25 ET
Summary
- Preferred shares and PFF often attract investors due to their yields and attachment to blue chip names, but the implications of perpetual securities are often overlooked.
- Preferred shares lack the protections and structure of fixed income and are sold largely to retail investors, but it is usually the issuer who benefits most.
- The asymmetric return distribution of newly issued preferred shares make them not worth the risk for low return.
Thesis
Preferred shares and iShares Preferred and Income Securities ETF ( PFF ) often attract investors due to their yields and attachment to blue chip names. But the implications of a perpetual securities are often glossed over and investors don’t understand the asymmetric return distribution they are signing up for. Lacking the protections and structure of fixed income, preferred shares are sold largely to retail investors as they have tax advantages (jurisdiction dependent), but ultimately it is the issuer who is getting the best bang for their buck. We break down the fundamental issue with perpetual securities and what type to avoid if you’re looking to stay invested.
Preferred Shares Overview
For those investors new to preferred shares, they are a relatively simple investment vehicle with some complex implications. In the capital structure they sit just above common equity and below any debt instrument. Should a default take place they would be entitled to a company’s assets before common equity and after debt, in practice they are likely to get scraps and the additional seniority provides very little protection. They do also get paid their dividend before common equity, but again if the common equity dividend cannot be afforded the preferred shares are likely not in too great of shape either.
The methodology or amount of dividend will be defined at the time of issuance similar to a debt facility, along with any additional clauses. Preferred shares can come in all shapes and sizes but most of the time public pref shares include some of the following characteristics:
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Non-cumulative : If a company decides to pause a preferred share’s dividend to conserve cash, the amount owed to pref shareholders does not continue to accumulate. This is very typical in bank issued preferred shares as it is a requirement to have it count as Tier 1 capital.
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Perpetual : The security has no preset date on when capital will be returned to the shareholder, extremely common.
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Callable : A defined timeline, calendar and/or terms for redeeming a preferred share at the issuers discretion, extremely common.
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Fixed to floating : A distribution may start off as a fixed % of the par value but after a certain time changes to be a benchmark rate + a predetermined spread.
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Fixed payment : A distribution is unchanging, when paid, as a fixed % of the issuance par value.
Additionally, some preferred shares may be convertible to equity, cumulative (as opposed to non-cumulative) or putable.
Even with an issuer they take on different characteristics depending on both their and investor’s needs at the time of issuance. Just scrolling through Wells Fargo's preferred page you can get a sense of the different levers that are used.
Why Companies Issue Preferred Shares
There are a few common reasons why companies decide to add preferred shares to their capital structure. Additionally there may be jurisdiction specific reasons, particularly for tax reasons that impact why a company may issue pref.
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Does not count as debt as dividends are still considered discretionary
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No voting rights
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Provides additional leverage to common equity as preferred shares don’t participate in higher earnings
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Flexible/customizable to what investors want and the issuer need
Implications of Structure
Now that we’ve covered the basic attributes of most preferred shares, we will dig into some of the subtle implications. The largest complexity and nuanced items for preferred shares are the fact that they are perpetual and callable. For ease of modeling we evaluate a theoretical preferred share that’s distribution is based off of a spread to a benchmark rate. That way there will be no interest rate risk and our theoretical investor will not be rewarded or hampered by the fixed payment.
Let’s walk through the scenarios of buying a preferred share at the time of issuance from a large well established issuer. The preferred share will contain the most common attributes, perpetual, non-cumulative and callable.
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Scenario #1 Business is Booming: The issuer’s business continues to improve, profits are up, leverage is down and overall risk has come down substantially. Because the financial worthiness of the issuer has improved so much the company is now looking to utilize its higher credit quality. The issuer calls the preferred share and issues a new preferred share at a lower rate. The investor’s capital is returned to them and they must now look to redeploy their funds.
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Resulting Return: The investor earned close to the prescribed yield for a given period (depending on how they reinvested their distributions). They however, did not receive any benefit from having correctly identified a worthy issuer, in fact you could argue they were penalized for identifying a well managed company by having their investment taken away.
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Scenario #2 Business as Usual: The issuer’s business is status quo, no major changes up or down. The preferred shares remain in the market because the rate continues to reflect the credit quality of the instrument.
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Resulting Return: The investor continues to hold the security if they choose and continues to get paid a dividend comparable with the risk they are bearing.
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Scenario #3 Business isn’t what it used to be: Results are deteriorating, leverage is up, prospects are down, overall risk of the issuer is up. The issuer cannot call the preferred shares as if they were to reissue, it would be at an even higher spread. The market recognizes this risk and the price of the preferred shares has fallen, reflecting not only a higher potential of impairment but also a risk now commensurate with the credit worthiness.
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Resulting Return: The investor likely continues to get paid the dividend but the value of the holding has decreased. Depending on how long they’ve held the security they could still have some level of gain (unlikely) or more likely they are holding a loss with no short term redemption.
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The examples are oversimplifications but all 3 exist (in addition to the default/bankruptcy scenario) in the market today. Our fundamental issue with preferred shares is that only scenario 2 is really a win. In Scenario 1, the investor ultimately got paid more than the risk they took, but it was short lived and they had to redeploy their capital. In Scenario 3, they likely lost value despite the continued dividend. Only the status quo (plus some range as companies have a cost to reissue) scenario provided the investor what they want for the longer haul. This asymmetric distribution of returns is very unappealing.
The chart below puts these scenarios in a visual format to highlight the capped upside of preferred shares but uncapped downside.
Author's Analysis
We should note here that not all investors buy their preferred shares at issuance. There are plenty of opportunities to find preferred shares trading below par value with upside potential.
Don’t all high yield instruments have the same issue?
The immediate thought that might come to mind is “how is that chart above any different for debt holds?” Their value likely trades down if the creditworthiness declines as well. The key difference is the perpetual vs fixed maturity schedule. Excluding the restructuring scenario, if the investor purchased a debt instrument instead at the time of issuance, as long as the company continued to survive until maturity the investor would be made whole on capital and interest. But preferred shares do not have this forced timeline to return capital, issuers only do so at their discretion and ultimately when it is in their best interest.
PFF - Doubling Down on the Fundamental Issue
PFF is the largest preferred share ETF in the US. It is very diversified, highly liquid, and has a low beta. The management fee is certainly on the high side, but that isn’t the biggest issue.
Author Analysis
PFF is indexed around the ICE Exchange-Listed Preferred & Hybrid Securities Index. It will add/subtract securities to align with the index. As a holder of the index, with 465 holdings, we could expect the performance to capture all 3 scenarios as defined above in different proportions. Except that there is a subtlety that makes PFF even worse of an investment.
Let’s walk through the situation when issuers call their preferred shares and reissue at more favorable rates. The initial issue is redeemed, and the ETF gets the capital back. Now the issuer reissues and the index adds this new issue to its holdings. Effectively always setting itself up for downside risk. In our view, if investors still find the need to hold preferred shares, they are better off identifying issuers with upside from either improvements in credit worthiness or changes in business context that make an issuer likely to clean up their capital structure and redeem the preferred shares even though they may be below par value.
As a constant buyer of preferred shares at or near par value we think PFF, be definition of its index, has a fundamental flawed approach for investing in preferred shares. On top of that, a 71% exposure to the finance sector and a high management fee lead to our suggestion of avoiding PFF as a long term hold.
Conclusion
We recommend investors avoid PFF and avoid buying preferred shares at the time of issuance. Instead we implore investors to instead search for opportunities within the preferred share market that would allow them to participate in improvements of the credit worthiness of an issuer and reduce the asymmetry of the return distribution.
For further details see:
The Fundamental Problem With Preferred Shares And PFF