Preffereds Could Be Pertinent Again in 2023

Mercifully, 2022 is drawing to a close. “Mercifully,” because this will be etched in the annals of financial market history as one of the worst on record for fixed income assets.

Translation: Advisors faced myriad headwinds in 2022 when it came to generating income for clients. Problem is investors still needed that income due to rampant inflation. Further compounding those woes is the point that rising interest rates usually punish high-yield asset classes – a scenario that was on fully display in 2022.

Just look at preferred stocks. As of Dec. 28, the ICE Exchange-Listed Preferred & Hybrid Securities Index is off almost 18% year-to-date. That index sports a 30-day SEC yield of 6.12%, which is high by the historical standards of preferreds. Fortunately, there is some potentially good news for clients that want access to the robust income streams offered by preffereds.

“Cohen & Steers found that preferred securities often have strong performance after rate hikes, outstripping other types of fixed income products like investment-grade and high-yield bonds. Since 1990, they have achieved an average 12-month return of 12.7 percent after rate hikes, compared to 10.2 percent for investment-grade bonds and 9.9 percent for junk bonds, according to the report,” reported Hannah Zhang for Institutional Investor.

Preferreds Pivotal for Income, Rebound Potential

Preferreds actually represent an educational opportunity for advisors because many clients don’t know that fixed income instruments can be attractively priced or too expensive as is the case with equities. Good news: Preferreds are currently offering big income on the cheap.

“Preferreds, therefore, offer a deeply discounted investment-grade-rated yield opportunity that may be able to participate in any risk aversion reversal predicated on any potential policy pivot that tempers central bank aggressiveness. This attractive entry point provides a bit of a backstop and balances the potential risks that the full pivot may not come as soon, or may not be as substantial as many expect,” according to State Street Global Advisor (SSGA).

Data confirm preferreds are inexpensive – as cheap as they’ve been in more than two years. Noting that par is $1, many preferred stocks currently reside as low as 80 cents. That’s a substantial discount.

“Given their hybrid nature, preferred securities were doubly impacted by duration-induced price declines and the impairment in equity growth and sentiment — falling by over 15% in 2022,” adds SSGA. “The steep decline, however, pushed the yield on preferreds to over 6% and the average price on the securities down to the mid-80’s.8 This is the first time, outside of the brief COVID crash timeframe, that preferreds were trading at this large of a discount to par.”

Other Important Preferred Points

As noted above, preferred stocks are hybrid securities, meaning they display properties of both stocks and bonds. However, that doesn’t mean preferreds’ correlations to equities and fixed income are the same.

“Over the past five years, preferred stocks tracked the performance of the Morningstar US Market Index closer than the Morningstar US Core Bond Index. The Bank of America Merrill Lynch Core Fixed Rate Preferred Securities Index shows a 0.78 correlation to the Morningstar US Market Index, while only a 0.59 correlation with the Morningstar US Core Bond Index,” notes Morningstar analyst Katherine Lynch.

Looked at differently, the prevailing wisdom, at least for the moment, is that stocks could rebound while bonds dither, indicating preferreds could outperform bonds in 2023.