INSIGHTS

On March 02, 2020

AAM Viewpoints – The Sky is Falling! The Sky is Falling!

Ok, maybe not (yet), but falling acorns in the form of the coronavirus and recent data showing decelerating U.S. business activity has many rethinking their asset allocation – especially income seeking investors.

10-year and 30-year Treasury yields are down over 0.60% in 2020, and both have recently set all-time lows. The same fears, which have sent yields plummeting, have erased all the S&P 500 gains in 2020, causing those who sought income through the equity market in 2019 to rethink that strategy.

As if income seeking investors didn’t have enough troubles in this low-rate environment, the search for yield has become even more challenging.

Where is an income seeking investor to go?

A potential source for higher yields in a low interest-rate environment may lie with preferred stocks. Preferred stocks are hybrid securities that combine characteristics of both common stock and bonds.

• Like common stock, preferred & hybrid securities represent ownership in a company and have the potential to appreciate (or decline) in price.
• Like bonds, they offer fixed or floating dividends, like a bond coupon, and often carry a credit rating from a recognized rating agency.

Preferred stocks generally offer a higher yield than similarly-rated bonds due to their lower claim on a company's assets in the event of liquidation. In addition to higher yields, they generally pay qualified dividend income, which is taxed at lower rates than ordinary income.

While many are drawn to preferred stocks as a source of higher yield, they have the potential to offer additional benefits to multi-asset portfolios.

As seen in the chart below, the broad-based, exchange-listed preferred stock index, the ICE Exchange-Listed Preferred & Hybrid Securities Index (“PHGY”), has exhibited a low correlation to major equity and fixed income indices. In fact, over the past two years, PHGY has a 0.547 correlation to the S&P 500 and a 0.025 correlation to the Bloomberg Barclays U.S. Aggregate Bond Index (“LBUSTR”).

Source: Bloomberg | Past performance is not indicative of future results

Additional comfort may be found in the fact that the broad-based preferred stock index has held up relatively well in recent equity sell-offs. In 2018, when the S&P 500 index sold off nearly 20%, the preferred stock index was down only 7%.

Source: Bloomberg | Past performance is not indicative of future results

As Chicken Little learned, there is no shortcut to the “king”

While preferred stocks can offer high, tax-advantaged income and diversification, these benefits come with risks that include, but are not limited to, credit, duration and call risk. Below is a brief description of each:

• Credit Risk – The possibility of default resulting from a borrower’s failure to repay or meet contractual debt obligations.
• Duration Risk – Given their fixed income-like features, the price of preferred securities is impacted by changes in interest rates. The longer a security pays fixed – or floating – income, the greater their risk to changes in interest rates.
• Call Risk – Another caveat of preferred stocks is a call feature which allows the issuing company to redeem shares on demand before they mature for a price specified in the prospectus.

Is exposure to a broad-based index acceptable?

Some argue that owning the “entire” exchange-listed preferred universe is not a prudent way to tap the potential benefits of preferred stocks and we agree.

While holding many issues can help with diversification, we feel a few slight tweaks to the broad-based universe can help mitigate risks associated with preferred stocks – specifically, duration risk and call risk.

Even with rates suppressed, and additional rate cuts projected in 2020, targeting preferred stocks with an option-adjusted duration of less than five years has the potential to help reduce volatility and provide additional ballast in one’s portfolio.

Additionally, to help mitigate call risk, avoiding securities trading greater than 105% of face value may help avoid securities likely to be called.

Interestingly, by incorporating these two simple screens, which the ICE 0-5 Year Duration Exchange Listed Preferred & Hybrid Securities Index (“PHLD”) does, a similar total return potentially can be achieved with a lower maximum drawdown and lower volatility.

Source: Bloomberg | Past performance is not indicative of future results

Source: Bloomberg | Past performance is not indicative of future results

One would think lowering duration, volatility, and call risk may sacrifice income return, but that sacrifice may be smaller than one would think. As seen in the chart below, the difference in annual income return between the broad-based preferred index (PHGY) and the low-duration preferred index (PHLD) was only 23 bps (basis points) since 2015.

Source: ICE Data Services | Past performance is not indicative of future results

Watch the falling Acorns

Maybe falling acorns don’t signal the end of the world, but they do remind us to keep an open mind and avoid shortcuts. In these uncertain times, “acorns” will most likely continue to fall, and low-duration preferred stocks may offer the potential “cover” that income-seeking investors are so desperately in search of.

CRN: 2020-0203-7993R