Count preferred stocks among the rate-sensitive assets that are being dragged lower by the Federal Reserve’s 2022 interest rate-hiking regime.
Advisors aren’t surprised by this. Preferred stocks and the related funds have extensive histories of being vulnerable to rising interest rates. A conundrum indeed, but preferreds also present advisors with a teachable moment and one that’s relevant in terms of engaging clients that aren’t familiar with the asset class and those that aren’t intimately familiar with the adverse effects of Fed tightening.
The long and the short of it is, high-yield assets and sectors are usually susceptible to downside when rates rise. It’s a reminder that financial markets never give participants something for nothing.
Struggling as they are, preferred stocks and funds remain relevant today. There’s a value proposition owing to this year’s declines, the ongoing need and a potential recession-protection benefits. Fortunately, there’s a less bad option and it comes by way of variable rate preferreds.
Understanding 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).”
The difference between variable rate preferreds and the traditional versions of these securities is tangible. Year-to-date, a basket of the variable rate fare is down 8.9% while the ICE Exchange-Listed Preferred & Hybrid Securities Index is lower by 14.5%. Likewise, the 2022 annualized volatility on that index is 13.6% compared to just 7.2% for the variable basket.
There are other important differences between the two types of preferred stocks, including the point that variable rate preferred dividends are tied to interest rates – a crucial detail to say the least.
“In contrast to this, floating rate preferreds pay adjustable dividends for the life of the preferred security or a minimum rate (‘floor’). The dividends adjust on a set schedule, typically every 3 or 6 months. The dividend payment is commonly determined by the 3-month London Interbank Offered Rate (LIBOR) – or an alternative such as a Treasury yield or SOFR (Secured Overnight Financing Rate) – plus a fixed spread, which is primarily a reflection of the issuer’s credit risk,” according to Global X research.
Variable rate preferreds offer clients other benefits over standard equivalents and those perks are relevant in the current market climate. Consider the elements of call risk and yield.
“Variable rate preferreds often have features that are not common in other types of securities. For example, variable rate preferreds typically have a call option when they switch from paying fixed rate dividends to floating rate dividends,” adds Global X. “This option allows the issuer to buy back the preferred at a predetermined price, typically at or just above par value. As a result, the price of these
securities reflects the yield offered and the risk of them being called. The yield on these securities is usually higher than securities without this feature, to compensate investors for this embedded call risk.”
Good news: Call risk is currently low because with interest rates rising, other financing options are increasingly unappealing for corporations.
Variable Rates, High Income
“Variable” implies that the yields on these preferreds are volatile, but that’s not actually the case. In fact, when measured against other fixed income assets, variable rate preferreds sport higher yields than everything but junk bonds.
Then there’s the added benefit of low correlations to other bonds, in part explaining by variable rate preferreds are beating broader bond benchmarks this year.
“Variable rate preferreds can be used within an existing fixed income allocation due to their relatively low correlation to traditional bonds. For fixed income portfolios consisting of assets like floating rate bonds and TIPS, variable rate preferreds can be added to a portfolio in an effort to both increase portfolio yield and provide diversification benefits due to the low correlations,” concludes Global X.
The point: Variable rate preferreds aren’t perfect in this environment, but they’re a lot more alluring and opportunity-laden than other bonds with above-average yields.