With the banks’ interest staying at 1% or less, many people are looking for a higher yield of return in the market.
The fixed income preferred shares and exchange-traded debt (“ETD”) becomes the new target as they offer 4–10% return and they have priority of distribution over ordinary shares (i.e. stocks that we buy at the stock market).
But what’s the catch and risks that we have to consider and look out for?
Risks
There are at least three risks to be aware of when investing in preferred stocks or ETDs to earn interest / dividend: credit defaults, maturity rates, and recall risk.
Credit default
Before the company default, if the credit rating deteriorates, the prices of preferred stocks, ETDs and corporate bonds will change accordingly, resulting in asset losses. The price of ETDs and preferred stocks will fall more than corporate bonds.
After the company defaulted, most of the remaining assets were unable to pay off their liabilities, which means insolvency.
Although preferred stocks and ETDs belong to the hybrid security and debt hybrid product, the preferred stocks are placed in the shareholders’ equity column of the balance sheet, and ETD is debt In the liability field.
Therefore, after debt negotiation and reorganization or bankruptcy and liquidation, the preference shares will receive almost no compensation (or a very small amount), and only corporate bonds and ETD will have the opportunity to get them. And the corporate debt ranks before ETD, and more can be obtained.
Maturity rate
Preferred stocks, ETDs, and corporate bonds will be affected by FED interest rates and cause price fluctuations. If the debt maturity date is relatively short, or is closer to the debt maturity date, it is less affected by the FED interest rate; otherwise, if the debt maturity date is longer, the longer the debt is due, the more the price is affected by interest rates.
In addition, when the debt maturity date is more than 10 or 20 years, or even over 50 years, the price will be affected by the company’s own financial status, the future development of the industry, and the national economy conditions and the international situation, etc., so prices are more likely to fluctuate and cause book losses.
Recall risk
Whether the debt can be recalled in advance (also called debt settlement) and what the purchase price would be, is one of the risks of investing in ETD and preferred stocks.
ETD and preferred stocks are more susceptible to recalls, because most ETDs and preferred stocks are usually recalled five years from the issue date (but not necessarily, sometimes only one or two years, depending on the length of the debt maturity date. When the debt is only two or three years from the issue to the maturity date, there is usually no recall date).
If you buy at a premium price before the recall date, the price is more than 26 or 27, it is quite easy to make less profit due to the recall. If you buy at a premium price after the recall, you will face a loss.
The recall date of corporate bonds is usually half a year to one year before the maturity date of the debt. In addition, some corporate bonds have a Make-whole call designed to reduce the loss of investors, so the losses caused by the recall can be reduced.
Therefore, as a rule of thumb, the purchase price of ETD or preferred stock preferably should not be greater than 25 + 1 to 2 times’ dividends, that is, not greater than 25.7 to 26.
When the company is not doing well…
There are several processes for a company to undergo recession to default.
The first is the suspension of dividends, and then the preference dividends. Because these two are stocks, it is legal to stop issuing their dividends.
If you buy accumulative preferred stocks, the company will need to pay back the accumulated dividends when the situation improves, but less than 10% of the preferred stocks in the United States are accumulative, and most of these preferred stocks are subject to taxes.
Next comes the handling of liabilities.
Although ETD is debt and interest cannot be owed, usually, the prospectus has deferred clauses that can legally defer interest for up to five years.
If the interest is still not paid, then debt negotiation and reorganization or bankruptcy liquidation procedure could be triggered.
After the company improves, the interest owed by the ETD must be given, so there is no distinction between accumulative and non-accumulative for ETD.
At this time, the remaining money is usually not enough to pay off the debt, let alone take care of the shareholders. So the so-called liquidation preference of the preferred stock is only a theoretical solution, usually after the liquidation there is nothing left.
As for corporate bonds and ETDs, debts are repaid according to the availability of collateral and the priority order of debt repayment.
Corporate bonds that average investors can buy are usually unsecured debt.
All in all….
Fixed income preferred stocks, ETDs, and corporate bonds have fixed interest rates, and have the advantage of capital preservation, but they also need to bear risks. The main risks include, but are not limited to, the three items mentioned in this article: adjustment of credit rating and compensation for breach of contract, The length of the debt maturity date, the rise and fall of the FED interest rate, whether the debt can be recalled in advance, and the purchase price.
Note: this is not investment advice. I’m not financial planning professional. Just sharing what is working for me as part of my investing strategy or what I have learned on my investment journey. Please be reminded to do your own research and consider your own circumstances before making any financial decisions. You could also check with your financial professional to understand what would be best for your situation.
