Clients, particularly retirees and those in the latter of their working lives, need income. Advisors know this. Problem is the Federal Reserve just isn't cooperating.
Amid the coronavirus-induced recession last year, the Fed took interest rates to historic lows, decimating yields on an array of conservative income-generating assets previously beloved by retirement investments. Today, the 30-day SEC yield on the ICE U.S. Treasury 20+ Year Bond Index is just 1.60% while the comparable metric on the S&P National AMT-Free Municipal Bond Index is a scant 0.84%.
Barring a surprising uptick in inflation, the Fed will likely keep rates low through at least 2023. That's a long time for income-starved clients to go dealing piddly yields on stodgy fixed income investments.
It'd be easy for many advisors to simply augment government debt exposure with corporate bonds. After all, Moody's Investors Service says global defaults across investment-grade and junk corporates will reach just 2.2% this year. That's slightly above the long-term average, but not high enough to imply high-yield debt will be excessively risk this year.
In other words, advisors have their hands full when it comes to locating yield. One way of ameliorating that scenario is with preferred stocks.
Preferreds are hybrid securities sporting both bond and equity traits. These stocks are issued by companies a la standard equity, pay fixed dividends akin to interest payments with bonds and are higher on the corporate asset totem pole than common stock but below corporate debt.
Historically, preferreds perform well in low interest rate environments and the yield scenario is alluring for clients. For example, the 30-day SEC yield on the ICE Exchange-Listed Preferred & Hybrid Securities Index is 4.40%. That stands out relative to the aforementioned bond benchmarks.
Not only that, but preferreds are generally less risky than many financially strained high dividend companies and junk bonds. That's good news. Better news is that advisors can do better for clients with variable rate preferreds.
Here's a simple definition of variable rate preferred stocks from S&P Dow Jones Indices: “A variable rate preferred stock pays a fixed dividend for a period until a trigger date is reached, at which point the dividend rate will float at a spread to a specified benchmark rate (Libor, Fed Funds or T-Bill rate).”
An advisor looking to sell clients on variable rate preferreds, which are accessible via some exchange traded funds, doesn't have to work hard because one of the obvious advantages is that this is a short duration (low rate risk), high-yield (robust income) asset class we're talking about. The short duration component is valuable today because when we get down to it, rates have nowhere to go but up.
“Currently, variable rate preferreds and high yield bonds offer an attractive balance of lower duration and higher yield in the fixed income space,” writes Global X analyst Rohan Reddy. “Variable rate preferreds typically pay a fixed coupon for the first 5 to 10 years of the preferred’s lifecycle before paying a floating rate based on the London Interbank Offering Rate (LIBOR) plus a pre-determined credit spread. Therefore, as rates increase, their coupons adjust higher. High yield bonds tend to pay fixed coupons, but they are largely issued with intermediate (such as 5 year) maturities.”
Other Perks With Variable Rate Preferreds
Variable rate preferreds have other benefits, including a tendency to perform well when junk bond spreads are tight, as they are today. Speaking of high-yield corporates, the broader universe of variable rate preferreds is rated, on average, BBB- compared to B+ for the average junk bond. These preferreds also merit consideration as a reflation trade.
“While inflation remains uncertain, we believe the odds of greater fiscal stimulus and economic activity could lead to rising interest rates sooner, rather than later, and investors would be wise to begin positioning their portfolios for this potential environment,” notes Reddy.
And if it's pure yield a client craves, variable rate preferreds check that box, too. The Global X Variable Rate Preferred ETF (PFFV) sports a 30-day SEC yield of 5.33%, nearly 100 basis points higher than the ICE Exchange-Listed Preferred & Hybrid Securities Index.
Related: How to Talk to Clients About SPACs