5 Ways the New Tax Law Affects Preferred Securities
Preferred Securities
5 Ways the New Tax Law Affects Preferred Securities After sweeping changes to the U.S. tax code, preferred securities continue to offer among the highest after-tax yields in the fixed income universe—comparable to high yield and better than muni bonds. Here are five things to know about preferreds and tax reform, from the impact on tax treatment and credit fundamentals to the potential scarcity of high-income investment options.
1. With modestly lower tax brackets but fewer write-offs,
the need for tax-advantaged income remains.
Although most individuals are likely to see a lower tax burden in 2018, we expect the appetite for tax-advantaged income to remain strong. The highest tax bracket will see only a small reduction (from 39.6% to 37%) and certain popular write-offs have been cut back, including a new $10K cap on state and local tax deductions and a lower limit on deductions for mortgage interest. Taxes may even increase for some people in high-tax states such as New York, California and Illinois. For those looking to keep more of what they earn, we believe preferred securities remain a compelling alternative to bonds.
Before- and After-Tax Income Based on New Tax Rates Before Taxes
As shown on the right, preferred securities currently offer an after-tax yield of 3.8% for investors making less than $479K—the same as high-yield bonds (which tend to be much lower quality) and higher than municipal and corporate bonds. The picture is the same for those earning more than $479K. The bottom chart represents lowduration indexes for investors looking to emphasize capital preservation over appreciation. We believe the income rates of preferred securities generally do not reflect their tax advantages the way that municipal bonds do, offering relative value.
After Taxes (Income >$479K)
Fixed Income Yields 8% 6%
6.2 5.4 3.8 3.7
4%
3.8 3.8
3.2 3.2 3.2
3.3 2.0 2.0
2%
2. QDI was maintained at previous levels, preserving the favorable tax treatment of preferreds. Many preferreds pay dividends rather than interest, thus treated as qualified dividend income (QDI) and taxed at a lower rate. The new law fully preserves the QDI tax rate at 15% for married households with taxable income below $479K, or 20% for income above $479K. Preferreds also tend to pay higher income rates than similarly rated securities, due largely to their complexity, including their subordinate position relative to bonds. This combination of favorable tax treatment and high coupons offers the potential for attractive after-tax income.
After Taxes (Income
5 Ways the New Tax Law Affects Preferred Securities After sweeping changes to the U.S. tax code, preferred securities continue to offer among the highest after-tax yields in the fixed income universe—comparable to high yield and better than muni bonds. Here are five things to know about preferreds and tax reform, from the impact on tax treatment and credit fundamentals to the potential scarcity of high-income investment options.
1. With modestly lower tax brackets but fewer write-offs,
the need for tax-advantaged income remains.
Although most individuals are likely to see a lower tax burden in 2018, we expect the appetite for tax-advantaged income to remain strong. The highest tax bracket will see only a small reduction (from 39.6% to 37%) and certain popular write-offs have been cut back, including a new $10K cap on state and local tax deductions and a lower limit on deductions for mortgage interest. Taxes may even increase for some people in high-tax states such as New York, California and Illinois. For those looking to keep more of what they earn, we believe preferred securities remain a compelling alternative to bonds.
Before- and After-Tax Income Based on New Tax Rates Before Taxes
As shown on the right, preferred securities currently offer an after-tax yield of 3.8% for investors making less than $479K—the same as high-yield bonds (which tend to be much lower quality) and higher than municipal and corporate bonds. The picture is the same for those earning more than $479K. The bottom chart represents lowduration indexes for investors looking to emphasize capital preservation over appreciation. We believe the income rates of preferred securities generally do not reflect their tax advantages the way that municipal bonds do, offering relative value.
After Taxes (Income >$479K)
Fixed Income Yields 8% 6%
6.2 5.4 3.8 3.7
4%
3.8 3.8
3.2 3.2 3.2
3.3 2.0 2.0
2%
2. QDI was maintained at previous levels, preserving the favorable tax treatment of preferreds. Many preferreds pay dividends rather than interest, thus treated as qualified dividend income (QDI) and taxed at a lower rate. The new law fully preserves the QDI tax rate at 15% for married households with taxable income below $479K, or 20% for income above $479K. Preferreds also tend to pay higher income rates than similarly rated securities, due largely to their complexity, including their subordinate position relative to bonds. This combination of favorable tax treatment and high coupons offers the potential for attractive after-tax income.
After Taxes (Income
