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Some high-yield asset classes are vulnerable to rising interest rates. That’s simply the cost of admission for accessing above-average levels of income and clients are being reminded of that this year.
Take the case of preferred stocks. Preferreds are hybrid securities, meaning they display traits of both bonds and equities. That’s part of the reason yields in this asset class are high. For example, the widely followed ICE Exchange-Listed Preferred & Hybrid Securities Index has a trailing 12-month yield of 4.74%.
That’s the good news. The bad news is that index is living up to preferreds’ rate-sensitive reputation, slumping more than 8% on a year-to-date basis. Obviously, that hinders income-hungry clients. Why take on that alluring yield if losses are following?
Fortunately, there might be some silver linings for advisors to ponder regarding preferreds and those points could indicate this income source is more attractive today than it was at the start of the year.
Preferred Points to Consider
There are significant differences between common and preferred stock, indicating traditional valuation metrics aren’t always applicable with the latter. However, it’s hard to ignore that following recent weakness in the group, preferred stocks are more attractively valued and sporting higher yields today than they were a few months ago.
“Preferred security yields have risen sharply as their prices have plunged this year—the average yield-to-worst of the ICE BofA Fixed Rate Preferred Securities Index is now close to 5%, compared to its 10-year average of just 3.9%. That’s up sharply compared to the last and a half; from July 2020 through December 2021, the average yield of the index was generally below 3%,” notes Collin Martin of Charles Schwab.
As noted above, valuing preferred stocks in fashion similar to common shares isn’t always relevant, but it’s also hard to ignore valuation anomalies, which preferreds offer today.
“While the price plunge may spook investors that currently hold preferreds, we think the entry point is looking more attractive,” adds Martin. “Over the last 20 years, the average price of the index has rarely been lower than where it is today. There are two clear outliers: the 2008-2009 financial crisis and the pandemic-induced plunge in March 2020.”
Perhaps compelling value is to be expected with preferreds enduring their second-worst start to a calendar year since 2010 as is the case today. However, underscoring preferreds’ fixed income-like traits, history indicates that the lower a preferred’s starting price is for an investor, the better long-term return prospects are.
Ways to Deal with Preferreds Today
A quick glance at the year-to-date showing of the aforementioned ICE Exchange-Listed Preferred & Hybrid Securities Index and it’d be easy for clients, even those clamoring for income, to be dismissive of preferreds. However, there are potentially attractive avenues for entering the asset class today.
“One way to combat interest rate risk with preferreds is by considering variable-rate or adjustable-rate preferreds,” concludes Martin. “These preferreds either have floating coupon rates, or are structured as fixed-to-float, meaning that they begin with a fixed coupon rate and then after a specified amount of time has passed, they reset based on a short-term reference rate.”
There’s something to that thinking. The Invesco Variable Rate Preferred ETF (NYSEARCA:VRP) is beating the ICE Exchange-Listed Preferred & Hybrid Securities Index by 200 basis points year-to-date.