Count preferred stocks as among the high-yield asset classes dealing with 2022 headwinds attributable to seven interest rate hikes by the Federal Reserve.
Of course, interest rate sensitivity is a two-way street, meaning that if the Fed dials back the pace of its rate hikes in 2023 and lays off that plan altogether, preferred stocks and exchange traded funds such as the VanEck Preferred Securities ex Financials ETF (PFXF ) could be prime rebound candidates.
Underscoring the point that preferreds are sensitive to rising interest rates, PFXF posted annual gains on five occasions in the six years ending 2021 – an era marked by low interest rates and accommodative Fed policy. History could bode well for PFXF in 2023 because preferreds typically rebound after annual declines. That was the case in 2019 after PFXF faltered in the prior year.
“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.
Potentially adding to the case for PFXF as a 2023 rebound candidate is that following a down year, broader preferred stock benchmarks often post double-digit upside the next year. Of course, financial market history doesn’t always repeat, but it often rhymes.
“With preferreds down nearly 13 percent in 2022 through November 30, we anticipate an attractive rebound in 2023,” noted Cohen & Steers.
Part of the case for preferreds, and thus PFXF, centers around the notion that the Fed’s 2022 rate tightening will show signs of paying off in 2023. Translation: Inflation materially declines to the point that rate hikes won’t be necessary, possibly setting the stage for bond yields to fall. That would allow rate-sensitive assets, including preferreds, to regain momentum. Plus, the asset class is viewed as more appealing than junk bonds and offers investors some tax benefits, too.
“The dividend income paid by preferred securities is taxed at 20 percent, significantly lower than the 37 percent tax for interest income earned by other types of fixed income products. In addition, preferreds offer diversification benefits because they have a low correlation with stock markets and other fixed income products, according to the report,” notes Institutional Investor.
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