Fixed-income investors should consider how preferred securities and related exchange traded funds may help benefit their portfolios.
“The questions on investors’ minds is, ‘How do I find income but not take on too much risk?’. We believe investors should consider preferred and capital securities,” Matthew Cohen, Head of Principal ETF Specialist Team, Principal Global Investors, said in the recent webcast, Solving for Income: A Preferred Solution.
Cohen explained that preferred securities are sometimes referred to as “hybrids” due to their combined debt and equity attributes. The securities are senior to common equity and junior to senior debt in the capital structure. They are issued by financial institutions, energy companies, utilities, and telecom companies, among others. Additionally, preferred stocks issue dividends on a regular basis, but investors don’t usually enjoy capital appreciation on par with common shares.
In 2001, Principal acquired Spectrum Asset Management, an industry leader in preferred securities. Spectrum is one of the largest specialized managers of preferred securities in the world. They focus solely on preferred and capital securities. The team has over 30 years of experience managing across a variety of credit, interest rate, and regulatory conditions. Their conservative approach leads to higher-quality securities, less prone to risks inherent to the broader market, such as reinvestment, call, and interest rate risks. Their approach also makes them price makers, not price takers. Investors can access their expertise by investing in the Principal Spectrum Preferred Securities Active ETF (PREF).
Marc Drummer, Managing Director and Portfolio Manager, Principal Global Asset Allocation, explained that in our current market environment, investors will have to balance their outcome investing with the amount of risk they are comfortable with.
“Even though there are risks (COVID-19, growth, etc.), we should be focused on delivering a return above the inflation rate right now. To do that, you have to take some risk. The questions we should always ask and answer is, ‘Am I being paid to take that risk?’,” Drummer said.
Drummer believes that yield opportunity is still available in preferred securities, pointing out that spreads on preferreds are meaningfully wider than their 10-year historical average. He also argued that while spreads widened due to COVID-19, this current environment is a medical crisis and not a financial crisis.
“We concluded in April that financials and preferred securities were likely going to lead us out of this crisis. Assuming no change in rates, tightening spreads would normally translate into a total return greater than the current coupon. In a time of uncertainty, it’s comforting to embrace the consistent return of a coupon,” Drummer said.
When incorporating preferred securities into a diversified investment portfolio, Drummer advised income-seeking investors to fit them in between investment grade corporates and high yield because of their risk to reward characteristics. Additionally, preferred securities offer exposure to qualified dividend income to help boost after-tax income.
L. Philip Jacoby IV, Executive Director and Chief Investment Officer, Spectrum Asset Management, also pointed out that preferred securities’ risk profile looks more like investment-grade credit based on their default rates. Consequently, preferreds offer comparable yield to speculative-grade debt with less credit risk than high-yield bonds.
Jacoby also explained that Spectrum’s active management helps better manage key risks associated with income investing. For instance, Spectrum targets credit quality through a top-down and bottom-up process that scores relative credit quality to reduce credit risk. Spectrum actively manages towards lower aggregate call risk on preferred securities by reducing exposure to overpriced call options that can lead to negative yield horizons. Lastly, they focus on securities with adjustable-rate coupons and high forward reset spreads, where negative convexity is a significantly lesser risk, to help better manage interest rate risk.
Financial advisors who are interested in learning more about preferred solutions can watch the webcast here on demand.