According to an analysis by UBS Financial Services, despite the decline in interest rates, investors can still find some robust income opportunities in the preferred stock market.

Preferred stocks combine attributes of both bonds and stocks. They are publicly traded on exchanges and also provide a quarterly income stream. Companies that issue these securities are typically banks and utility companies.

The yield of these instruments can exceed 5%, and for investors, this income may have tax advantages. Generally, the dividends of preferred stocks are taxed at the qualified dividend rate, which is 0%, 15%, or 20% based on the investor's taxable income. In contrast, interest income from bonds is taxed as ordinary income, with rates as high as 37%.

Retail Investors and Preferred Stocks

Preferred stocks sold to retail investors have a fixed face value of $25. The dividends can be fixed throughout or "fixed-to-floating," which means the dividend adjusts after a specific period.

Although many preferred stocks have a long maturity or are perpetual, they typically have a "call date" after which the issuer can redeem these securities.

In an environment of declining interest rates, issuers may redeem preferred stocks, forcing investors to seek alternative investment targets. Frank Sileo, a senior fixed income strategist at UBS, said this activity is more common in the $1,000 face value market, as these securities usually have variable rate dividends, while the $25 market is primarily fixed rate.

Advertisement

Similarly, Sileo added that if investors buy preferred stocks at a discount but the securities are subsequently redeemed at par, they gain a profit but also face the risk of reinvestment, as it may be difficult to find assets with comparable yields.

Furthermore, truly perpetual preferred stocks are more sensitive to interest rate changes, leading to price volatility. "When interest rates decline, prices rise significantly; when they rise, prices fall," Sileo said.

"People sometimes say, 'I buy them for the income, I don't care about price volatility'—until the price volatility happens," Sileo said. "Then you'll see unrealized losses on the books, which can be unsettling."Other Risks to Consider

Another risk to consider is that investors holding preferred stocks have a lower priority in the company's capital structure compared to bondholders. In the event of a liquidation of the issuer, preferred stockholders are paid before common stockholders, who are typically the last to be paid, but after bondholders.

This also means that investors should pay attention to the credit rating of the issuer when purchasing preferred stocks. Companies with a credit rating of BBB- or higher, according to Standard & Poor's, are considered investment grade.

For investors looking to buy a portfolio of preferred stocks and gain exposure to different companies, they might consider investing in an ETF. The iShares Preferred and Income Securities ETF (PFF) has an expense ratio of 0.46%, and its total return for 2024, including reinvested dividends, exceeded 11%.

Additionally, there is the First Trust Preferred Securities and Income ETF (FPE), which has an expense ratio of 0.84% and a total return of 12% for the year 2024.