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In 2021's low-yield environment, a favored destination for advisors and income-hungry clients is preferred stocks.
Enthusiasm for these hybrid securities is palpable, particularly when it comes to exchange traded funds. There are 14 dedicated preferred ETFs on the market today, six of which have north of $1 billion in assets under management and another that's knocking on the door of the $1 billion club.
From a broad perspective, preferreds are rewarding investors this year. The ICE Exchange-Listed Preferred & Hybrid Securities Index is higher by 4.73% year-to-date and sports a still impressive 30-day SEC yield of 4.18%. That's well in excess of what clients are earning on 10-year Treasuries and broad equity benchmarks.
Obviously, the yield is captivating. However, that 4.73% returned by the ICE Exchange-Listed Preferred & Hybrid Securities Index is alluring in its own right considering it was accrued in less than seven months and that preferreds have fixed income-like traits, meaning this isn't a barn burner of an asset class.
Managing Client Expectations
Obviously, advisors are constantly managing client expectations, but for the income-oriented crowd, it's something that's necessary regarding preferreds because some market observers believe the story is shifting to almost entirely income away from a mix of capital appreciation and income. In fact, the current preferred landscape is conducive to exactly what the asset class is intended to be: a destination for long-term investors.
“The bad news is that prices of preferred securities have rarely been higher than they are today. We see little room for price appreciation at this point, and a greater risk that prices will fall, albeit modestly, from current levels,” writes Charles Schwab's Collin Martin. “Investors may still consider preferreds today, but they should always be treated as long-term investments. Preferreds have long maturity dates—or no maturity dates at all—so investors should be willing to hold them for long periods of time, earning the income while riding the ups and downs of their price volatility.”
One way of looking at the above sentiment is that of good news is already baked into preferreds and that's accurate. Remembering that banks account for massive percentages of preferred issuance – the financial services sector accounts for over 60% of the aforementioned ICE Exchange-Listed Preferred & Hybrid Securities Index – paints the picture.
The Federal Reserve recently sign off on capital return plans for big banks and that's relevant to preferred investors because banks must payout preferred dividends prior to meeting payouts on common equity. So with that, it's fair to say preferred dividends are safe, which is a clear positive because preferreds pay some of the highest coupon payments of all fixed income assets. Still, that also indicates upside catalysts are hard to come by.
“There’s very little room for price appreciation going forward. Coupon payments should be the driver of total returns over the next six to 12 months, not price gains,” adds Martin. “The average price of the ICE BofA Fixed Rate Preferred Securities Index is approaching $108, not far from its all-time high of $108.7 reached in 2013.”
Other Risks to Consider
Historically, preferreds perform well when interest rates are low. If speculation intensifies that the Fed is going to speed up its rate hike timeline, preferreds could be vulnerable.
“Higher long-term Treasury yields could pose a risk to preferred securities’ prices if they lead to higher borrowing costs for banks,” according to Martin. “If Treasury yields rise as we expect, investors may demand higher yields from preferred securities to compensate for the greater risks they offer compared to U.S. Treasuries.”
Additionally, price swings in preferreds were uncommonly wide last year. Perhaps that was the result of the coronavirus pandemic.
Add it all up and while preferreds are still solid ideas for long-term income investors, advisors need to remind clients that this isn't a risk-free bet, either.
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