For investors seeking tax-advantaged income, municipal bonds should not be the sole option considered in fixed income. Preferred securities, issued primarily by investment-grade companies, currently offer among the highest yields on an after-tax basis in fixed income for most tax brackets.
For income-oriented investors, high-income payments and yields are key characteristics of preferred securities. Preferred securities are a type of investment that combines characteristics of both stocks and bonds, typically offering higher yields. Preferreds are lower in the capital structure than senior and subordinated debt and, as a result, usually have higher yields than similarly rated bonds. Investors may want to consider low-duration preferred securities to emphasize capital preservation over appreciation.
These securities also offer attractive after-tax yield but with reduced interest rate sensitivity. Investors seeking income-producing investments and willing to take additional risks for higher yields could consider preferreds. Still, investors with more conservative to moderate risk tolerances might want to consider investment-grade corporate bonds instead since this category offers yields of approximately 5% or more with less credit risk than the preferred stock category.
The average yield-to-worst of the ICE Bank of America Fixed Rate Preferred Securities Index now offers a yield of more than 5.3%, as yields have risen sharply over the past few years. This is at the high end of the 10-year pre-pandemic range but well off its recent high of 7.8%.
Because preferred securities have long-dated or perpetual maturities, changes in the longer end of the treasury yield curve can influence the price and yield of preferred securities. So unless the 10-year rate continues to decline significantly from here, there may not be much short-term appreciation potential.
Qualified dividends, depending on tax brackets and income limits, are generally taxed at 0%, 15%, or 20%. Qualified dividend income (QDI) paid by preferred stocks is typically taxed at a top rate of 20% versus 37% for interest income (and a Medicare surcharge of 3.8% for both). This can be particularly advantageous for investors in high tax brackets. Some preferred stocks pay interest and not qualified dividends, so it's important to know what you own and the tax consequences.
Preferred securities compare favorably to municipal bonds on some key risk factors, although municipal bonds are often perceived as lower-risk securities than preferred stocks. Both have historically low default rates over the past few decades. The preferred market is also well represented by less cyclical and strong-cash-flow companies that investors trust to make regular payments.
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David Rosenstrock, CFP®, MBA, is the Director and Founder of Wharton Wealth Planning (www.whartonwealthplanning.com). He earned his MBA from the Wharton Business School and B.S. in economics from Cornell University. He is also a CERTIFIED FINANCIAL PLANNER™.