16-Apr-2022
The price action this year has highlighted two related dynamics for preferreds investors. First, is the relative lack of coupon structure diversification. More than three-quarters (at least going by our investor Preferreds Tool) of the exchange-traded market is fixed-coupon. And second, is the fairly high-quality make-up of the sector with close to half of the sector having either investment-grade issuers or being in heavily-regulated industries such as Utilities.
What this combination of features translates into is the fact that most of the sector is made up of high-quality / low-coupon stocks. Normally, we would think of these securities as relatively defensive, however, the market environment year-to-date of rising Treasury yields and range-bound credit spreads hit these higher-quality / fixed-coupon securities particularly hard. This was caused by their longer-duration profile (a direct outcome of their lower coupons) and the fact that their lower beta to moves in credit spreads didn’t save the day because credit spreads didn’t move a whole lot.
What this suggests is that rather than thinking of allocation in terms of a single dimension of lower or higher quality investors should rather think across multiple dimensions of coupon structure (i.e. Fix vs. Fix/Float), coupon level (i.e. low-coupon vs. high-coupon), convertible vs not and credit quality (i.e. investment-grade vs. sub investment-grade or unrated).
Building a diversified portfolio based on individual preferreds can be a hard lift for some investors, however, it’s not really necessary and may not be appropriate for everyone. The good news is that it can be easier to build a diversified portfolio by allocating to preferreds funds. A side benefit of using funds is that they also provide investors additional diversification dimensions such as active vs. passive management and institutional vs. exchange-traded / retail preferreds sub-sectors.
Of course investors don’t have to choose one or the other. It’s perfectly sensible to have a number of high-conviction individual preferreds coexisting with a number of preferreds funds in income portfolios.
Preferred ETFs with a focus on Fix/Float stocks are the Invesco Variable Rate Preferred ETF (VRP) and the Global X Variable Rate Preferred ETF (PFFV). These funds have held in much better than broader preferreds funds year-to-date.
ETFs that are focused on institutional preferreds include the First Trust Institutional Preferred Securities and Income ETF (FPEI) as well as the Principal Spectrum Preferred Securities Active ETF (PREF). These funds have held in better than those focused on the exchange-traded / retail sub-sector. This is likely due to the fact that most institutional preferreds are Fix/Float and the fact that the institutional market is less prone to the boom-bust flows due to rapidly changing risk sentiment of retail investors.
Unlike the majority of preferreds and preferreds funds which have a higher-quality flavor, a fund that has a higher-yield allocation profile is FPE with a majority sub investment-grade / unrated profile. Higher-yielding preferreds typically carry higher coupons which shortens their duration profile and their higher yields can more quickly offset capital losses due to rising Treasury yields.
Within the ETF space we continue to like FPE with a 4.73% TTM yield which has put up pretty strong historic returns which are competitive with many sector CEFs. It features an overweight of institutional and Fix/Float stocks as well as active management. Investors with a higher risk appetite should have a look at the 8.12% yielding Virtus InfraCap US Preferred Stock ETF (PFFA) which carries some leverage and has a high-yield focus.
Fans of preferred CEFs should also have a look at the John Hancock trio of funds: HPI, HPS and HPF. These funds have a relatively low financials allocation, about half that of the other preferred CEFs which provides better sector diversification. They also have a sizable allocation to corporate bonds which shortens up their duration profile.
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