Those holding preferred stock portfolios got caught flatfooted when US yields rose during the tapering news of 2013. In terms of high-yield assets, The iShares S&P US Preferred Stock Index Fund (PFF) was one of the largest underperformers during this period. Much of this can be attributed to duration, which is seldom used in the analysis of preferred stocks. The higher an asset's duration, the more vulnerable it is to a rise in interest rates. I have outlined this in two prior articles and wanted to focus on what are appropriate hedges for those interested in hedging preferred stock portfolios. I wrote this article from the perspective of PFF hedging because traditional hedges used for a preferred portfolio that worked in prior cycles did not work well in 2013. Some PFF constituents lost over 20%. However, long-only investors that do not hedge might want to reassess which high-yielding ETF they prefer and switch to ETFs with better characteristics for a changing macro environment. This article might offer them some food for thought. I look at two distinct macro environments; one of rising rates (2013), and one of falling rates (2014).
The ETFs and hedges I looked at are:
(click to enlarge)
Some quick notes on the above table:
- The carry is the difference in yields.
- The hedge risk represents the amount the hedge can go against you. IYR and XLF have unlimited upside, but the other ones are bound by par, or by their many bond-like constituents.
The chart below shows that high-yield alternatives like the junk [SPDR Barclays Capital High Yield Bond ETF (JNK)] and high-yield [iShares iBoxx High Yield Corporate Bond ETF (HYG)] ETFs vastly outperformed PFF. The time period which best represents the rise in the 10-year yield is that from May to end of September 2013 (bottom panel). As the 10-year yield (TNX INDEX) climbed, the PFF underperformed:
What made this downdraft different is that it was duration driven, as opposed to credit worries that were the main drivers of prior pullbacks.
Recently we have careened from tapering fears to emerging market/slowdown fears, giving us two contrasting scenarios in which to see what the best hedges are for each. This is confirmed with a Google trends term search chart:
(click to enlarge)
I create the same graph as the top price graph for YTD 2014. It's a short time frame, but covers the dramatically different environment for high-yielding assets. The 2014 YTD price graph is the inverse of the 2013 tapering graph, as the 10-year yield is falling and higher credit and longer duration PFF outperforms:
So with tapering concerns, low duration and lower credit will outperform, and with EM/slowdown concerns those same two attributes will underperform. This makes sense because:
- Lower duration means lower sensitivity to higher yields as one's principal is not locked into the old lower rates for an extended time.
- Lower credit becomes safer when the higher yields are a result of an upturn in the economy, i.e. credit spreads tighten.
I will try to demonstrate this with correlation runs as well. The tapering period shows JNK and HYG were less correlated to TNX (the yield on the US 10-Year Note):
The better hedges were the longer duration assets and the Fed Funds Futures. Let's go back to the price performance during the tapering period and look at some of the other hedges:
Being short TLT and LQD or the Fed Fund March Futures were all excellent hedges. For the long-only investors, they were the worst assets to be long. Some notes about the Fed Fund Futures:
- They settle to the effective Fed Funds Rate (FEDLO1 Index). The price is 99.85, and the rate is calculated as 100-99.85, so by going short the future you are going long the rate at .15%. During the tapering this rate shot up to over .6, so over four times the investment.
- To short one future requires a margin of $500, and 1 point equals $4,167. So the move during tapering would have made around $2000 per future. Downside would be futures going to zero, which is $625 (.15 * 4,167). The current effective Fed Rate now is .07. This is a very cheap and effective hedge for higher yields due to the asymmetric payout profile, but should only be considered by qualified investors.
These same hedges should have underperformed in the 2014 YTD period, for similar reasons the HYG and JNK outperformed. Sure enough:
So HYG and JNK should be superior hedges in this instance and inferior longs, as the new environment favors long duration and higher credit. This is true:
- To effectively hedge a portfolio of preferred stock one has to establish if it has to be a duration hedge (improving economy) or credit hedge (deteriorating economy). A very rough transition area would be around 2.6-2.8% in the US 10Y yield. The direction of the move is pertinent. Being at 2.7% and coming from 3% is wildly different than being at 2.7% and coming from 2.4%.
- In periods where duration pressure reduces asset valuation, the traditional peers HYG and JNK should be substituted with higher duration hedges (LQD, TLT, etc.). LQD has a higher duration as well as less of a credit spread advantage. TLT has the highest duration. Long-only investors will want to think about switching into HYG and JNK.
- In periods where credit pressure reduces asset valuation, HYG and JNK are superior hedges. Long-only investors will want to think about switching out of them for higher credit, longer duration assets like LQD and PFF.
- The LQD performs decently as a PFF hedge in both scenarios, but will underperform HYG and JNK as a PFF hedge in the credit scenario.
- TLT performs well in the duration scenario, but can be an awful hedge when markets are in turmoil due to a flight to safety.
- Fed Funds Futures are a cheap way to hedge duration for professional investors.