Tax savings and high yields drive preferred securities

Capital requirements for banks provide tax-advantaged benefits to financial advisers and their clients in the form of preferred securities (debt securities that share some characteristics with stocks).

Investments in fixed income products have grown by billions of dollars due to the attractiveness of favorable after-tax returns on municipal bonds, investment-grade corporate bonds and high-yield bonds. Parametric report for last monthIt is an asset management firm owned by Morgan Stanley that specializes in direct indexing and other custom strategies.Many preferred securities, issued primarily by banks, insurance companies or other financial services companies that meet minimum capital regulatory standards, pay investors qualified dividend income that is taxed at a 20% federal rate for the wealthiest filers. This is significantly lower than 37% of ordinary profits..

read more: Two ways to avoid capital gains when selling a home

Risks of this asset class include subordination to senior debt in a default scenario; It spread to the financial services industry last year. Managing director Kevin Rignac said the bank was increasing its exposure to commercial property through its lending to commercial property. Parametric Fixed Income TeamStill, preferreds have generated more return than municipal, corporate and high-yield bonds over the past decade, according to the firm’s reports, and investment in preferreds has reached $300 billion in the U.S. and $1 trillion globally, Linyak noted in an interview.

“It’s popular with financial advisors and individual investors,” he said, noting that private clients and wealth management professionals are “paying a lot of attention.” Taxes, Tax Alpha, and Tax Benefit Solutions“In recent years, qualified dividend income has become a tax-advantaged income for advisers.”

Other large asset and wealth management firms are also starting to take notice of this potential opportunity. Fidelity Investments and Charles Schwab Each offers tools to screen the attractiveness of products and potential red flags.

“Investors seeking income and willing to take on some risk for a higher yield could consider preferred stocks, while those with a more conservative to moderate risk tolerance may want to look at investment-grade corporate bonds instead,” Schwab director Colin Martin wrote in a March report on the asset class. “Investment-grade corporate bonds offer lower credit risk than preferred stocks and average yields of 5% or more. We always encourage investors considering preferred stocks to consider holding for the long term, given their longer maturities.”

At the time, Schwab’s outlook remained “positive,” but Martin’s memo noted that “the strong earnings performance of the past few quarters may be difficult to replicate.”

read more: QSBS excludes capital gains over $10 million from tax

in Last month’s notes Lawrence Gillam, chief fixed-income strategist at LPL Financial, said the firm’s research department is similarly cautiously optimistic about preferreds, which have “outperformed many other positive (and core) sectors so far this year” and are a “favorable representation within the sector” because active managers “are better able to take advantage of relative value opportunities between markets than ETFs,” he wrote.

“These institutions will likely be able to weather the storm of a downturn while continuing to pay dividends on their preferred stock,” he wrote. “While we still recommend a majority of fixed-income allocations to core fixed income, for income-focused investors who don’t mind taking on additional credit risk, preferred stocks may be an attractive investment worth considering.”

In addition to after-tax returns, preferred securities have a “low correlation with traditional fixed income” and pre-tax returns comparable to U.S. junk bonds. Another report from last year According to Parametric, the firm combines active management with proprietary technology and additional tools, such as separately managed accounts, to reduce fees and provide tax efficiencies. Tax loss recovery.

” in [investment-grade] In the fixed income world, few alternatives can match the potentially high after-tax yields of preferred stocks, the report by Linyak and Parametric director James Benadam said. “With their unique structure and low correlation, preferred stocks are an attractive complement to traditional fixed income. Active managers can exploit inefficiencies It’s specific to this asset class.”

read more: Get your tax fix: Unlimited annuities protect ultra-wealthy clients

Active management also helps investors avoid holding shares in riskier smaller banks, Mr. Linyak said. Most preferred securities have investment-grade ratings, slightly lower than senior debt, and default rates for these instruments average less than 1% per year, roughly the same as comparably rated corporate bonds.

“They’re offering 20% ​​coupons instead of 37% and most of these are very solid names,” Mr. Lignac said. “I think you’re taking on some subordination risk and some financial risk in exchange for some very strong returns.”