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On Wednesday, the Federal Reserve, as expected, did not lower interest rates. However, the central bank did imply that as many as three rate cuts could be on the table over the remainder of 2024, potentially providing some support to rate-sensitive asset classes.
That includes preferred stocks and the related exchange traded funds. Preferreds are often described as “hybrid securities,” meaning they possess traits of both bonds and equities. And that they do, but the fixed income side of the preferred stock equation ruled the day in 2022 when the largest preferred ETF plunged 18.2% compared to a 13% loss for the Bloomberg U.S. Aggregate Bond Index.
Preferreds rebounded last year after Treasury yields steadied following a spike and that resurgence has continued into this year VanEck Preferred Securities ex Financials ETF (PFXF) higher by 5% year-to-date as of March 19 while “the Agg” is in the red.
That could signal that opportunity exists with PFXF and preferred stocks as the Fed draws closer to finally reducing borrowing costs.
Why PFXF Matters
As its name implies, PFXF does not hold preferred stocks issued by banks and other financial services issuers and that’s an interesting feat when considering banks are the biggest issuers of this type of security. PFXF’s exclusionary tactics have served investors as the ETFs has beaten its largest rival and the Agg by wide margins over the past three years.
PFXF strutted its stuff last year, turning in an impressive showing against the backdrop of some of the largest bank failures in U.S. history.
“Beyond the obvious benefits of excluding financials in the current market, ex-financial preferreds generally also offer a number of other benefits over the broad preferreds market that investors might find attractive,” notes VanEck’s Coulter Regal. “Historically, these include higher yield, greater sector diversification and strong relative performance compared to the broad preferreds universe.”
The $1.59 billion PFXF, which sports a tantalizing 30-day SEC yield of 6.85%, makes up for the lack of financial services exposure by devoting more than half its weight to preffereds issued by utilities and REITs. That explains some of PFXF’s rate sensitivity, but the ETF’s diversification is attractive relative to its peers.
“With banks making up roughly 40% of the preferreds market, any loss of confidence in the sector could severely impact the portfolios of investors. Just like many are looking to manage their Mag 7 equity exposure, we believe that the same risk management is warranted in the preferreds market as well,” adds Regal.
Preferred History Worth Remembering
While acknowledge that market history doesn’t always repeat, but often rhymes, the history of preferred stocks following the end of tightening cycles.
Barring a surprise, that’s where the Fed is at now and that could be constructive for PFXF going forward even if rate cuts don’t materialize over the near-term.
“On average preferreds have returned over 15% in the two years following the final rate hike of the cycle,” concludes Regal. “This average return increases to over 20% if you exclude the 2005-2008 rate cycle which was impacted by the Global Financial Crisis. While past performance is not a predictor of future outcomes, this data provides a favorable historical foundation.”