In today’s volatile market, investors are searching for ways to diversify their fixed income allocations without sacrificing yield or total return. Two asset classes often considered for this purpose are preferred stocks and high yield bonds. While both offer attractive yields, their risk profiles, tax treatment, and diversification benefits differ in meaningful ways.
What Are Preferred Stocks and High Yield Bonds?
Preferred stocks are hybrid securities, typically issued by companies with strong balance sheets and investment-grade ratings at the senior unsecured level. However, the preferred securities themselves are usually rated as high yield. They offer yields similar to non-investment grade bonds but compensate investors primarily for negative convexity rather than default risk.
Preferred stocks behave like callable bonds, meaning their prices don’t always move favorably when interest rates change. This is called negative convexity: when rates fall, issuers can redeem the shares, capping price gains; when rates rise, prices can drop sharply. Investors earn higher yields not because of high default risk, but as compensation for this call-related price risk.
High yield bonds, on the other hand, are issued by companies with lower credit ratings. Investors in these bonds are compensated mainly for taking on default risk.
Key Differences and Investment Considerations
1. Issuer Quality and Default Risk
Preferred securities are generally issued by companies with higher credit ratings, which can translate to lower default risk compared to high yield bonds. Historical data shows that default rates for preferreds have remained materially below those of high yield bonds, even during periods of market stress such as 2008 and 2023[1].
2. Diversification Benefits
Preferred stocks offer low correlations to both equity markets (S&P 500) and fixed income indices (Bloomberg US Aggregate Bond). Over the past 15 years, preferreds and hybrid securities have also shown very low sensitivity to interest rate changes across the curve. This makes them a powerful tool for diversifying income streams and reducing overall portfolio risk[1].
3. Yield and Tax Treatment
Yields for preferred stocks and high yield bonds are currently similar. However, many preferred securities offer qualified dividend income (QDI), which is taxed at a lower rate than ordinary income. This can make the after-tax yield of preferreds comparable to, or even higher than, high yield bonds for many investors[1].
4. Relative Value and Spreads
Spreads between high yield bonds and preferred securities are relatively tight compared to historical averages. Given the higher quality and diversification benefits of preferreds, this presents an opportunity to allocate at attractive relative values[1].
Risks to Consider
Both preferred stocks and high yield bonds carry risks, including credit risk, interest rate risk, and sector concentration risk. Preferreds also have unique risks such as negative convexity and subordination in the capital structure. It’s important to review fund prospectuses and consult with financial professionals before investing[1].
Conclusion
Preferred stocks and high yield bonds each offer compelling reasons for inclusion in a diversified portfolio. Preferreds stand out for their lower default risk, attractive after-tax yields, and strong diversification benefits. High yield bonds, meanwhile, may offer higher returns in certain market environments but come with greater default risk.
Pairing both asset classes can help investors balance risk and reward, especially in uncertain markets. As always, consider your investment objectives, risk tolerance, and consult with a financial advisor before making allocation decisions.
References
Disclaimers: High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
Asset allocation does not ensure a profit or protect against a loss. (34-LPL)
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. (26-LPL)
All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.
This material was prepared by North Square Investments