For investors considering preferred securities today, there is good news and bad news.
The good news is that preferred securities can offer investors higher income payments than many other fixed income investments, and large banks are generally in good shape to make those payments to preferred security holders.
The bad news is that prices of preferred securities have rarely been higher than they are today. We see little room for price appreciation at this point, and a greater risk that prices will fall, albeit modestly, from current levels.
Investors may still consider preferreds today, but they should always be treated as long-term investments. Preferreds have long maturity dates—or no maturity dates at all—so investors should be willing to hold them for long periods of time, earning the income while riding the ups and downs of their price volatility.
Positives for preferred securities
1. Financial institutions passed the Federal Reserve’s stress tests. Each year, the Federal Reserve conducts stress tests on the largest financial institutions to test how they would perform during financially stressful conditions. The tests cover hypothetical scenarios, including shocks to economic growth and the labor market, and the results showed that the largest financial institutions could likely handle those shocks. Even in the Fed’s “severely adverse” scenario—assuming the unemployment rate rises above 10%, gross domestic product falls for seven straight quarters, and stock prices drop 55%—the largest banks would all have capital levels above the minimum risk-based requirements as prescribed by the Fed.1 Preferred securities issued by financial institutions make up more than half of the preferred security market.
Large financial institutions would still be well capitalized in a severely adverse scenario
Source: Federal Reserve, “Dodd-Frank Act Stress Test 2021: Supervisory Stress Test Results,” June 2021. The Common Equity Tier 1 Ratio is calculated as common equity tier 1 capital divided by risk-weighted assets and is meant to show how well a financial institution can withstand financial stress.