Hybrid Hype Warranted in This Environment

Following last week’s 3.05% decline, the S&P 500 is lower by 23.62% year-to-date and barring a miracle, green before the end of 2022 is highly unlikely. In fact, just don’t bet on it.

However, some asset classes warrant some level of hype – modest as though levels should be. Surprisingly, preferred stocks are part of this conversation. Surprising because rising interest rates are taking a toll on this high-yield asset class this year. Not surprising because owing their equity and fixed income traits, preferreds epitomize a “hybrid” asset class.

Fortunately, there might be some silver linings for advisors to ponder regarding preferreds and those points could indicate this income source is more attractive today than it was at the start of the year.

Preferreds Pertinent Today

It’s understandably difficult to get excited about any risk asset these days, including preferred stocks, but this could also be an appropriate time for advisors to consider hunting for bargains.

There are significant differences between common and preferred stock, indicating traditional valuation metrics aren’t always applicable with the latter. However, it’s hard to ignore that following recent weakness in the group, preferred stocks are more attractively valued and sporting higher yields today than they were a few months ago.

“Preferred securities exhibit both equity and debt characteristics. While investors often overlook preferreds, they present a unique opportunity to seek income with low correlation to both traditional stocks and bonds and low beta to stocks,” notes Matthew Bartolini, head of SPDR Americas Research. “Preferred securities are subordinate to secured debt in a company’s capital structure (though superior to common stock), but they are often issued by banks and insurance companies and tend to be investment grade with attractive yield.”

While preferred performance is dour this year, there are some points in favor of these securities that advisors may want to acknowledge. Notably, default rates are low across the corporate bond spectrum – relevant regarding preferreds because these stocks are issued by companies.

Second, the vast majority of preferred issuers have the capital to service the dividends attached to those securities. In fact, many are boosting common stock payouts as well, signaling the capital is there to meet these obligations.

Those are potentially alluring traits at a time when so many other corners of the bond market are subjecting clients to undue risk without adequate reward.

More Preferred Perks

One of the primary benefits of preferreds is above-average income, but it shouldn’t be overlooked that these securities can reduce a portfolio’s volatility profile, too.

“As the impact of higher borrowing costs continues to ripple through the broader economy, it’s imperative not to sacrifice too much credit quality in the pursuit of incremental yield,” concludes Bartolini. “The hybrid nature of preferred shares means that their volatility profile is lower than that of common stocks — both traditional US large caps and the actual underlying common stocks of the same preferreds — and credit-sensitive high yield bonds. Therefore, preferreds add high income potential without taking on outsized volatility.”

Bottom line: Now offering value, preferreds may be worth considering as volatility-reducing, income-generating plays.

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