Potential Benefits And Risks Of Preferred Stocks

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Includes: IPFF, PFF
by: Christopher Dhanraj

Summary

Preferred stocks are hybrid instruments that exhibit the characteristics of both equity and debt securities.

In the current market environment, preferred stocks have felt pressure from rising interest rates but have performed relatively well versus other high-yielding instruments.

We believe this outperformance could continue if economic growth continues to support U.S. credit issuers and should equity markets remain stable.

Key points

  • Preferred stocks are hybrid instruments that exhibit the characteristics of both equity and debt securities. Their unique credit quality, security structure, coupon type, and volatility profiles can help them serve as an attractive diversifier in a multi-asset portfolio.
  • In the current market environment, preferred stocks have felt pressure from rising interest rates but have performed relatively well versus other high-yielding instruments.
  • We believe this outperformance could continue if economic growth continues to support U.S. credit issuers and should equity markets remain stable. Tailwinds for the broad universe of preferred stock also include relatively strong capitalization of financial institutions, strong U.S. economic fundamentals, and their floating rate characteristics.

Overview of preferred stocks

Preferred stock is a special type of equity share class that shares some properties of both equity and debt instruments. The security lies in the middle of a company's capital structure - above common stock in the event of liquidation, but below traditional debt. This caveat presents a subordination risk that is priced into preferred stock's price and yield, which helps explain why preferred stock tends to yield higher than traditional bonds.

Banks and financial institutions are the main issuers of these securities because they can help satisfy regulatory requirements to support their liabilities. This is reflected in major indexes - the sector composition of the S&P U.S. Preferred Stock Index is about 84% financials and real estate.

Chart 1: S&P U.S. Preferred Stock Index is predominately financials and real estate

S&P U.S. Preferred Stock Index Composition
GICS 1 Sector Sector breakdown (%)

Chart 1: S&P U.S. Preferred Stock Index is predominately financials and real estate

Source: S&P, BlackRock, as of August 8, 2018

For investors, preferred stocks offer a variety of potentially attractive portfolio functions. Since they can appreciate like a stock but pay coupons like a bond, they can provide investors distinctive benefits. Those include:

1. Higher yield potential: As discussed, preferred stocks typically have higher yields than their corresponding corporate debt counterparts. Chart 2 highlights how the 12-month trailing index yield of the S&P U.S. Preferred Stock Index has been higher than many fixed income exposures. The increased income potential drives an obvious argument for their addition to a fixed income portfolio.

Chart 2: Preferred yields versus fixed income asset classes

Chart 2: Preferred yields versus fixed income asset classes

Source: Thomson Reuters, BlackRock, Bloomberg

Notes: Yield is represented by the yield to redemption for fixed income assets. The S&P Preferred stock's yield is represented by its 12-month trailing yield.1 Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

2. Favorable risk characteristics: Despite their relatively high yields, the risk characteristics of preferred securities have recently been more favorable than those of equities and some fixed income assets. The reason why is intuitive: Issuers of preferred securities have benefited from strengthened fundamentals in the post-crisis growth regime, boosting their creditworthiness and diminishing their perceived riskiness. On the equity side, the limited direct equity participation of preferred shares can help minimize their volatility relative to pure equity exposures. Chart 3 shows how the addition of preferreds to a fixed income portfolio has increased income and reduced risk in potential portfolios as the allocation to preferreds is increased.

Chart 3: Preferreds may increase income and reduce risk in this potential fixed income portfolio

Chart 3: Preferreds may increase income and reduce risk in this potential fixed income portfolio

Source: BlackRock, as of August 8, 2018

Notes: The "no preferreds" portfolio is comprised of a 25% allocation to the iBoxx $ High Yield Corporate Bond (NYSEARCA:HYG), Markit iBoxx USD Liquid Investment Grade, Bloomberg Barclays Agg, and JPMorgan EM Bond Indexes. The subsequent portfolios continue 23.75%, 22.5%, and 20% to the 5%, 10% and 20% preferred portfolios.2 Preferred stocks are represented by the S&P U.S. Preferred Stock Index. Yield is the 12m trailing index yield. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

3. Diverse return stream: Preferred stocks have lower historical correlations to traditional stocks and bonds, which means they tend to move in different directions when market conditions change. Depending on the market environment, this may allow preferred shares to help mitigate downside risks from falling equity markets.

Chart 4: Correlation table

Chart 4: Correlation table

Source: BlackRock, as of August 8, 20183

4. Credit quality diversification: The credit quality of preferred stock issuers varies significantly across issuers. At the index level, we find that 80% of the securities within the S&P Preferred Stock Index have a credit rating from BBB+ to B-. The higher skew toward the BBB+ rating than in high yield benchmarks can help explain why the broad index has a lower yield than high yield, but higher yield than investment grade (figure 5).

Figure 5: Credit breakdown of preferreds, investment grade, and high yield

Figure 5: Credit breakdown of preferreds, investment grade, and high yield.

Source: BlackRock, as of August 8, 2018. Notes: Ratings are received from S&P. Unrated securities do not necessarily indicate low quality. Below investment-grade is represented by a rating of BB and below. Ratings and portfolio credit quality may change over time.

Preferred stock in the current market environment

It's important to note that preferreds have performed well in 2018 relative to other higher-yielding, longer-duration products with similar yield profiles. While it is true that preferred stocks may see price declines along with other traditional long-term bonds in a rising rate environment, the losses may be offset by the potential yield and equity appreciation.

Additionally, because we expect the rate rises to be gradual, we wouldn't expect to see big downward spikes in preferred prices. Preferred stocks may also be attractive due to the fact that they're issued mainly by financial companies, which have historically tended to do well in rising rate environments. For example, monthly returns of the S&P 500 Financial Sector Index have a 0.54 correlation to changes in the 2-year U.S. Treasury yield over the last five years, which is greater than the 0.3 correlation to the 2-year to the S&P 500.4

Key risks to monitor include those broadly to other asset classes: trade war developments, rapid tightening of financial conditions, and a slowdown in global growth. While we do not expect the latter two to occur soon, the former is difficult to forecast. Historically, preferreds have helped insulate equity investors from pure equity market drawdowns, but they typically lose more than IG and HY counterparts.

Chart 6: YTD performance of long duration asset classes

Chart 6: YTD performance of long duration asset classes

Source: BlackRock, Thomson Reuters, as of August 8, 2018. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Conclusion

Historically, the higher yields, diverse return streams and credit quality, and favorable risk characteristics have provided preferred investors with a complement to their multi-asset portfolios. During periods of rising interest rates, preferreds have done well versus other fixed income exposures given their high tilt toward financials and equity-like upside. Still, preferred stocks may continue to feel pressure from rising interest rates. Elsewhere, tightening financial conditions and trade war risks are broad risks to monitor for preferred stock. Nonetheless, the merits of preferred stocks may be appropriate for multi-asset investors looking to diversify their return streams and source of yield.

Article was originally on iShares.com.

© 2018 BlackRock, Inc. All rights reserved.

1 Yield to redemption is the annualized rate of return an investor would receive if they held the bond to maturity (redemption). The 12-month trailing yield is the percentage of income an investment has paid out in the past 12 months.

2 The equal-weighted allocation to the identified indexes was selected as to represent a hypothetical global bond portfolio. In order to demonstrate the potential risk and yield profile of incrementally adding an allocation to preferred stocks, the weights between the original four indexes were reduced equally. Risk is represented by the annualized standard deviation of daily returns from August 2013 to August 2018.

3 Correlation is used in statistics to measure how strong a relationship between two variables is. It is calculated by taking the covariance of two variables and dividing it by the product of their individual standard deviations. The range of values for correlation is bounded by 1.0 on an absolute value basis or between -1.0 and 1.0.

4 Source: Thomson Reuters, as of 8/14/2018.


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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.