In this article, we take a look at the preferreds sector as well as how various key market dynamics are guiding our allocation. This is how preferreds look across the broader income space:
The sector's yield is roughly in the middle of the pack, consistent with its decent-quality profile. However, for higher-rate taxpayers in taxable portfolios, preferreds look more compelling than the table suggests because they tend to pay qualified dividends taxed at 15-20%. This means that on a tax-adjusted basis, they offer a higher yield than high-yield corporate bonds. In other words, for investors in high-bracket taxable accounts, preferreds are particularly compelling, not only because of the post-tax yield advantage but also because of their higher quality than the average high-yield corporate bond.
Apart from this, relative-value advantage in taxable accounts, preferreds can be attractive as "drier-powder" securities. This is what we call decent-quality securities that are likely to be resilient through periods of market volatility. This allows investors with a "drier-powder" allocation to scoop up higher-yielding assets that have fallen more. Investors who are always "all in" in the highest-yielding / high volatility holdings don't have recourse to this base of capital, and so cannot as readily take advantage of market drawdowns.
Preferreds also remain attractive relative to similarly-rated corporate bonds. Although the yield advantage of preferreds over bonds has fallen, there is still around 0.8% of excess yields in the asset class.
A few dynamics in the preferreds market are worth mentioning. One, credit spreads are on the tight side as the following chart shows. This is not at all surprising and it is exactly what is happening in other credit sectors as well. What it does mean however is that care should be taken by investors who are not impressed by the yields on offer.
There is a tendency by some investors to reach for higher-yielding assets when overall yields fall to keep the yield on their portfolio at a stable level. This strategy allocates to increasingly riskier assets as valuations richen. This pro-cyclical investment strategy is unlikely to deliver in the longer term as it will tend to hold the riskiest securities at the peak of the market, meaning that the compensation for holding them is unlikely to be sufficient for their risk. Rather, reducing exposure to the riskiest / highest-yielding securities when valuations are expensive is more likely to deliver better results.
A final note on the sector has to do with Bank commercial real-estate exposure. Recall that CRE has been a slow-burning problem area of the market. Banks are the dominant issuer of preferreds so it can be difficult to avoid exposure to them. The yields in the Bank preferreds space are roughly aligned with CRE exposure on their books. So, some investors will find that VLY preferreds are paying fat yields, and this is largely explained by their large CRE holdings. This means that investors need to evaluate how much of CRE exposure they are comfortable with via their bank preferreds holdings.
In our allocation, we continue to avoid passive ETFs that primarily allocate to the $25-par market. This is for two reasons. One, the $25-par market remains fairly expensive vs. the OTC market, as shown in the chart below.
This is largely because of the two main players in this market being passive ETFs and retail investors. Passive ETFs are not interested in valuations - they will buy anything if it is in the index. And while retail investors are not blind to valuations, they are, by and large, limited in the amount of relative value analysis they can undertake.
Two, passive ETFs don't typically do a good job of managing corporate actions in their funds (something we have described in a separate article) which leads to slow-moving value destruction.
The valuation of the $25-par market is likely to get worse rather than better. This is because while the overall preferreds market is expected to grow, the $25-par market has continued to contract. Issuers have redeemed close to $7bn of the market this year, while issuing around $2.4bn. This follows $3.7bn in net redemptions in the past year. A shrinking $25-par market is likely to lead to an even more expensive valuation relative to OTC preferreds.
This means that in the $25-par exchange-traded space, we continue to focus our allocation on individual preferreds, the odd active ETF and CEFs. Holding individual $25-par preferreds (rather than via passive ETFs) allows investors to sidestep the expensive part of the market as well as focus on securities with the desired coupon profile (e.g. floating-rate, Fix/Float, fixed-rate, SOFR vs. CMT etc.).
In the individual preferreds space, we like 3 types of securities. First, we like fixed-coupon, investment-grade (or near) securities. These should outperform in case of a macro shock, when longer-term interest rates would typically move lower and credit spreads wider. Lower long-term rates would support the price of these longer-duration assets, while their credit spread widening should be relatively limited, as it tends to be for higher-quality credit assets. This bucket includes preferreds like Morgan Stanley Series F (MS.PR.F) and Wells Fargo Series L (WFC.PR.L), trading at yields of 6.95% and 6.3% respectively. Recall that MS fixed a number of their Fix/Float preferreds including F. MS is currently redeemable but trades at $25 in stripped price terms, meaning a redemption will not result in a price hit.
Second, we like what we call win-win securities. These are below-"par", Fix/Float securities trading close to their first call date. A redemption would result in a relatively high yield-to-call, and a failure to redeem would result in a significant rise in yield. This includes mortgage REIT preferreds like DX.PR.C and NYMTM which would move up to double-digit yields if not redeemed, as the following chart shows. The yield-to-call of the two stocks are near or above double-digit levels as well.
The third individual preferred bucket are floating-rate preferreds. The yield curve remains inverted, which favors floating-rate securities, even as the Fed starts to cut rates. It also provides a pocket of assets which should perform well if longer-term rates shoot up unexpectedly. This bucket includes preferreds like the 7.6% yielding Bank USB Series A (USB.PR.A), 7%-yielding Insurer MetLife Series A (MET.PR.A) and the mortgage REIT pair AGNCN/NLY.PR.F with low double-digit yields.
A final key advantage of individual preferreds is that they do not require investors to pay fees to managers (both CEFs and ETFs) or to wear inefficient CEF leverage. That said, individual preferreds are not for every investor, and diversified actively-managed preferreds funds can have their place in portfolios.
As far as ETFs, they can have a place in investor portfolios, however, as we highlighted above, we would focus on the actively-managed ones. The two we have held are the First Trust Institutional Preferred Securities and Income ETF (FPEI) and the Virtus InfraCap US Preferred Stock ETF (PFFA). The former is focused entirely on OTC preferreds and the latter straddles both exchange-traded i.e. $25-par market as well as the OTC market. PFFA tends to allocate to the higher-yield stocks, particularly in the Energy sector.
Unfortunately, both have fairly high fees for ETFs at 0.85% and 0.8% respectively. PFFA also uses leverage. These two ETFs have outperformed the broader preferreds fund space over a 5 year period. FPEI can be particularly useful for investors to balance out their individual $25-par holdings with institutional holdings as well.
In the CEF space, we like the Flaherty suite of 5 CEFs (e.g. DFP, FFC, FLC, PFD, PFO) as well as the Cohen & Steers Limited Duration Preferred and Income Fund (LDP). The Flaherty suite funds have slightly different fees, but the discounts are taking that into account. We would highlight PFO and FFC in the suite. These funds will benefit once short-term rates start to move lower, which would decrease their cost of leverage.
A note of caution on the Nuveen CEFs such as JPC and NPFD, whose yields are well above the average of the sector. That is only an artifact of Nuveen trying to fight off Saba's activism by hoping distribution hikes will tighten discounts enough to ward off Saba's interest. The distribution coverage of JPC is around 65%.
In our view, the Nuveen funds are the least attractive in the suite due to their leverage caps which causes them to deleverage pretty regularly, locking in economic losses. This is a factor we have discussed a number of times. It is also why JPC has underperformed the sector by around 1% per annum over the last five and 10 years in total NAV terms.