2024’s Fixed Income Winner: Can Preferred Stocks Repeat the Magic?

The last few years have been a return of the halcyon days for fixed income investors. The Fed’s rate action has produced an interesting environment with many fixed income and bond asset classes providing high yields not seen in years. For some subsectors, the stars have truly aligned.

That includes preferred stocks.

After stellar returns in 2024, preferred stocks still could have more room to run. Offering tax-advantaged income, high yields, and lower overall volatility than equities and some bond asset classes, preferred stocks could be a great choice for portfolios.

A Top-Notch 2024

When it comes to bonds and fixed income asset classes, preferred stocks generally fall on the staid side of the line. These equity/bond hybrids feature steady dividend payments and a par value that investors receive back when the preferred stock matures or is called. As a result, they generally don’t bounce around, trade at slight discounts/premiums to par, and are mostly there for the yield.

But when the Federal Reserve (Fed) started raising rates, many investors in preferred stocks fled.

The reverse was true last year. The sector’s juicy yields—as high as 8%—as well as dwindling inflation and the Fed’s potential to start cutting rates made preferred stocks too good to pass up. And with that, the asset class became one of the best performing fixed income sectors all year.

The ICE BofA Diversified Core U.S. Preferred Index rallied over 23% from its lows, allowing preferred stocks to post a 10%+ return in 2024. That compares to a 7.6% return for junk bonds and 4.5% return for investment-grade corporate debt. The bond market as a whole—as represented by the Bloomberg U.S. Aggregate Bond index—managed to produce total returns slightly above 1% for the year.

But in that surge, yields for preferred stocks have drifted lower and now some investors have begun to wonder if the big rally in the sector was all it had. Is there any gas left in the preferred stock tank?

Strong Tailwinds

The answer to that question could be yes.

First of all, the income is still very juicy when compared to other fixed income asset classes. Despite the dip in yields, preferred stocks are still paying between 5.6% to 7.3% on average. What’s more, despite the dip in yields, the spread between preferred stock and comparably rated senior debt have only widened. Senior loans are often considered a comparable asset class given their similar placement in the bankruptcy ladder.

This chart from asset manager Cohen & Steers shows the current extra yield investors can get in preferred stock over senior loans an extra 152 basis points worth of income. ¹

Source: Cohen & Sterns

What’s interesting about preferred yields and those spreads happens to be some of its advantages versus other fixed income asset classes.

One of the biggest happens to be taxes. For the vast bulk of the preferred sector, their dividends count toward the lower tax treatment of qualified dividends. For investors in the top tax bracket, that’s just 23.8%, including the Medicare surcharge. This is very advantageous when compared to other forms of investment-grade or junk debt, which is taxed as ordinary income—up to 40%. For example, investors in the top tax bracket would have to earn over 9% in investment-grade bonds to get the same yield as preferred stock today.

The best part is that high yield comes with much less volatility than junk bonds or other high-yielding fixed income types. Because of their placement in the bankruptcy ladder, preferred stocks have more ‘security’ than other bonds. Looking at the historical median rolling 36-month standard deviation of returns over the last 15 years, preferred stocks clocked in at just 6.34%. This compares to over 15% for the S&P 500 and 8.75% for junk bonds. This is critical considering the current interest rate uncertainty, geopolitical issues, and macroeconomic concerns amid rising inflation.

Preferreds Still Make Sense

So right now, preferred stocks are paying very juicy, tax-advantaged yields with low volatility. That’s a match made in heaven for fixed income seekers. As such, they still deserve a spot in your portfolio.

Getting them isn’t hard, but it’s not easy either. That’s because most preferred stocks trade on the over the counter bulletin board (OTCBB). This can lead to wide bid ask spreads or very low volumes. Most preferred stockholders—insurance companies and big institutional investors—tend to buy them and hold them until they mature. Our screeners here at Dividend.com do include preferred names, but again, going the individual route may be difficult.

To that end, ETFs and broad funds may make sense. And luckily, there are enough passive and active choices in the sector. Active management in preferreds may provide a little edge over indexes. However, the general nature of the preferred market doesn’t add additional credit research. Usually, active managers in the space add other bonds—like senior loans or junk—to help boost returns.

Preferred Stock ETFs

These funds are selected based on their ability to tap into preferred stock and their assets under management. They are sorted by their one-year total return, which ranges from 6.3% to 11.2%. Their expense ratio ranges from 0.23% to 0.84%, while they have AUM between $1B and $15.4B. They are yielding between 4.6% and 7.4%.

All in all, preferred stocks were a fixed income darling during 2024. But investors shouldn’t be so quick to give them up. They still offer great yields, tax advantages, and lower volatility than many other bonds. With that, they should be bought.

Bottom Line

Preferred stocks had a good 2024, providing some of the best returns in fixed income. Now, within the new year, they could still deliver great gains. High yields, tax advantages, and low volatility await those investors who take the plunge.

¹ Cohen & Sterns (November 2024). 3 Reasons to own preferred securities today