PGX: Rising Rates Are Bad News For Preferred Equities

Summary

• Long-term rates have been skyrocketing and the Treasury bond market crashing.
• Investors should pay attention to the bond market crash because it may proceed to another crash in risk assets such as stocks, preferred equities, and junk bonds.
• Due to their convexity, preferred equities can decline substantially given an increase in inflation and long-term interest rates.
• Preferred equity ETFs such as PGX carry immense exposure to banks which are particularly exposed to the ongoing situation due to their high leverage and Treasury assets.

The past three months have seen a clear shift in the market regime. We have gone from a recessionary environment with low-interest rate expectations to an inflationary environment with rising interest rates. The increase in interest rates has been most extreme for long-dated bonds which have recently seen acceleration up to the upside.

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The increase in long-term rates has brought about a crash in the long-term bond market. The long-term Treasury bond ETF (TLT) has lost nearly 20% of its value since August. Many investors believe Treasury bonds are low-risk assets, however, they carry immense inflation risk. As inflation increases, investors are not willing to invest in assets with yields below inflation, thus bonds decline and rates rise as we're seeing today.

Investors, regardless of their appetite for fixed income investments, should be keeping a close eye on the ongoing bond market crash. Historically, a rise in the 10-year Treasury bond yield has preceded a correction or crash in the stock market. We're currently seeing one of the most intense declines in the bond market, meaning we may soon see a similar decline in stocks and other "risk assets".

In my opinion, preferred equities may take the biggest near-term hit under the new market regime. Preferreds have greater exposure to long-term rates than most assets. Even more, most preferreds are concentrated in the financials sector which I believe is at high risk of seeing volatility due to the rise in inflation which may force the Fed to hike rates. This situation may soon cause a crash for popular preferred equity ETFs such as the Invesco Preferred Portfolio ETF (NYSEARCA:PGX).

Preferred Equities Are Not Preferable

PGX's price is directly inversely correlated to its dividend yield. Its dividend yield is tightly correlated to higher-yielding corporate bond yields. The recent rise in long-term

Analyst’s 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.