Preferred Stocks Are In The Sweet Spot

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October 26, 2015 3:46pm NYSE:HYG NYSE:PFF

money and investingMichael Fabian:  For retired investors seeking a low volatility income stream, it hasn’t gotten much better than owning preferred stocks this year. 

With the major averages reeling with concerns over global growth, the domestic banks and insurance companies who make up the majority of preferred stock issuance have quietly been plodding along with relatively good results.

First and foremost investing in preferred stock isn’t a “set it and forget it” portfolio strategy, instead there are many underlying dynamics in play that can influence price action and relative attractiveness.

Interest rates are a dominating factor, since most preferred stocks have maturity dates 20-30 years in the future.

For example, when Treasury yields rise, the attractiveness of the incrementally higher income from preferred stocks is diminished because of the incremental step up in credit risk.

As a result of longer duration bonds yields falling this year, preferred stock investors have reaped the rewards of owning longer duration securities.

With credit risk largely making up the other side of the equation, what’s interesting is that preferred stock ETFs such as the iShares U.S. Preferred Stock ETF (PFF) and PowerShares Preferred Stock ETF (PGX) have diverged from other high yielding options such as the iShares High Yield Corporate Bond ETF (HYG).

One reason for this anomaly is that the top issuers in HYG are dominated by large holdings in the communications and energy sectors, which have experienced fundamental headwinds during this correction.

In this instance, a lack of diversification has enabled preferred stock ETFs to sidestep tumultuous areas of the market.

PFF and PGX have over 80% of their holdings allocated to industry groups within the financial sector such as banking, financial services, insurance, and real estate.

Furthermore, contrary to high yield bonds, preferred stocks have a few fundamental tail winds that could allow them to continue their hot streak.

With the Federal Reserve mulling a rate increase into year-end, banks are set to capitalize on a general increase in loan revenue and net margins.

With the longer end of the Treasury yield curve set to remain relatively low, this puts preferred stock yields, which average between 5.5-6%, a very attractive place to park excess cash.

For clients in our Strategic Income Portfolio, we have dedicated a portion of our alternative sleeve to holdings in popular preferred stock ETFs. 

We categorize alternative assets as non-correlated or hybrid assets that don’t always react to changes in the economy or interest rates in the same way that stocks or bonds do.

As a result, preferred stocks have been an excellent performance and income contributor this year, and we expect that they will likely remain a relatively low volatility opportunity for income investors.

One word of warning for new investors in ETFs such as PFF or PGX is to monitor the future price action carefully, and size your position appropriately given the general sense of risk in the market.

Conditions can change rapidly, and as we witnessed in 2013, preferred stocks can exhibit a good amount of volatility in changing interest rate landscapes.

If our analysis is correct, we should continue to see good relative performance, but always place discipline above conviction.

This article is brought to you courtesy of Michael Fabian from FMD Capital Management.

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