Interest Rate, Call and Duration Risk
Preferred security values may rise or fall with changes in interest rates. Prices tend to drop when interest rates rise and often more dramatically for preferreds due to their lack of or long maturity. Conversely, when interest rates decline, previously issued preferreds typically become more attractive, and demand drives the price up. In addition to price fluctuations, callable preferreds may be called if interest rates drop, leaving the investor with proceeds to be reinvested at a lower rate. This is often referred to as reinvestment risk. When a preferred is callable, it tends to limit the appreciation in its price that could be expected when interest rates decline.
A call feature also creates uncertainty as to whether an investment in a callable preferred will remain outstanding, creating duration risk. Investors risk losing an investment paying a higher rate of interest when rates have declined and an issuer decides not to call in its shares.
Credit, Default and Suspension Risk
The ability of an issuer to meet its financial obligations on schedule-the issuer’s credit-is a critical concern for investors. Defaults occur when a company fails to make a dividend or interest payment to a shareholder as scheduled and as specified in the offering documents. Suspension occurs when an issuer does not make a scheduled payment. Unlike with bonds, in most cases preferred issuers may suspend payments within the guidelines of the offering documents, and not go into default. The risk of default and suspension is greater for non-investment grade issues than for investment grade issues.
Most issuers with outstanding debt are evaluated for credit quality by the major rating services, such as Standard & Poor's (S&P), Moody's Investors Service (Moody's), and Fitch, which provide a measure of relative credit risk. Investors can check the rating of an issuer prior to making an investment by contacting a financial advisor or through various websites. This information also is commonly found in a preferred’s prospectus or prospectus supplement. Preferreds rated BBB or higher by S&P, Baa or higher by Moody's, and BBB or higher by Fitch are widely considered "investment grade". Any credit ratings assigned to preferreds may not reflect the potential impact of all risks on the market value of these securities. Credit ratings do not reflect an investment’s value. Investors should remember that a credit rating of a security is not a recommendation to buy, sell or hold securities and may be subject to review, revisions, suspension, reduction or withdrawal at any time by the assigning rating agency.
Some issuers are not rated by any rating service. A non-rated issuer or security is not investment grade, yet the issuer is not necessarily uncreditworthy nor would it automatically be low rated. Some issuers do not want to pay the credit rating agency fee and/or do not have any debt outstanding. Non-rated issuers typically offer higher yielding securities than rated issuers and investors should consider those higher yields to be a sign of potentially greater risk. Information provided by the issuer or the analysts covering the issuer, along with an assessment of general business and industry conditions, may be used to further evaluate the strength of the company. Public companies usually must register with the Securities and Exchange Commission (SEC) and provide information periodic information, including quarterly and annual financials. Investors should use these documents, as well as the prospectus for the specific preferred offering, as tools to assist in issuer assessment. Not all securities are suitable for all investors.
Liquidity Risk
Preferreds are usually less liquid than common stock and the establishment and maintenance of an active trading market is not guaranteed. An investor’s ability to sell a preferred at a desired time and market price can be affected by several factors, including the issue rating and size. Many preferreds are listed on a national exchange and many broker-dealers maintain an active secondary market which allows the option to resell shares at prevailing market rates, which could be more or less than the amount of the original investment.
Event Risk
An issuer’s ability to repay its creditors may be affected by events related to the issuer and its industry, along with others, including, but not limited to prevailing global and regional economic and political conditions, taxation, and governmental regulations. Such events could also lead to ratings downgrades, if applicable.
Business Cycle Risk
All issuers are affected by general downturns in business conditions. High yield issuers typically have riskier business strategies and balance sheets reflecting greater leverage, and are at greater risk from such downturns, affecting their business and ability to make dividend payments.