Investors seeking yield often turn to traditional allocations, such as high-dividend stocks, investment-grade corporate or high-yield bonds. Preferred shares (“preferreds”) frequently go overlooked—but this unique asset class offers several advantages worth considering.
Preferreds are income-generating securities that are generally considered hybrid investments, meaning they share characteristics of both stocks and bonds. Preferreds can appreciate in value, just like common shares. Preferreds also pay a fixed or floating dividend, much like a bond’s coupon. The designation “preferred” refers to their treatment relative to common shareholders: Preferred investors have priority claims to dividend payments and company assets in the event of liquidation. Preferred investors, however, are subordinate to bondholders and other creditors.
Here we’ll explore the case for preferreds and the role they can play as a diversified income generator within portfolios, illustrating how relative to certain traditional market segments they have:
- Attractive yields
- Low correlations
- Less volatility
Capturing attractive yields
If yield is a key reason to consider preferreds, how does the asset class stack up against other income-generating choices? As shown below, preferreds compare favorably to high-dividend stocks, investment-grade corporate bonds and the broader bond market. While they yield less than high yield bonds, it’s worth pointing out that the index representing preferreds shown below is nearly all investment grade rated.1
Key takeaway: A 5%-plus yield for a group of primarily investment grade rated securities is worth considering for the income generation portion of a portfolio.
Targeting portfolio diversification
One of the basic principles of portfolio construction is ensuring portfolios are properly diversified, seeking to balance risk and return by including assets with low correlations. A way to examine the potential diversification benefits of an asset class, and its use case, is to understand its correlation profile. For instance, if a fixed income exposure has a low correlation to other bond strategies but is highly correlated with equities, then its inclusion into the fixed income sleeve of a standard 60/40 equity/bond allocation may do two things:
- Improve the diversification profile within the bond allocation
- Make the total portfolio more equity sensitive
If that’s the intended goal, inclusion could be a good idea. If it’s not, it reinforces why understanding the cross-asset correlation profile of an exposure prior to implementation should be on the investor’s portfolio construction checklist. For preferreds, as they are both bond- and stock-like, their correlation profile is low relative to both asset classes, as shown below. Their correlation to basic US Treasuries is very low at 0.09 over the last 15 years (based on monthly returns). They also have lower than 0.50 correlation to equity sensitive high yield bonds and to equities themselves—from all parts of the world.
Key takeaway: Preferred shares have low historical correlations to traditional stocks and bonds, indicating that their return patterns may be differentiated throughout certain market environments, resulting in a potential portfolio diversifier.
Seeking income with less volatility
As a result of preferred shares having both bond- and stock-like features, the volatility profile of preferreds has historically been lower than that of pure common stocks, while being just a touch below that of credit sensitive high yield bonds, as shown below. For this analysis we used the historical median rolling 36-month standard deviation of returns over the last 15 years, as a rolling measure can account for the cyclicality within an asset class. It is also more constructive than periodic returns, as one can examine outliers. For instance, preferred shares became more volatile than both high yield bonds and US large-cap stocks during the financial crisis due to the sector concentration within the assets class: The majority of the holdings within the Wells Fargo Hybrid and Preferred Securities Aggregate Index are from the financial sector.2 The latter point may be helpful in understanding return patterns if there is a market event that creates short-term volatility within the financial sector.
To further test this notion of the preferred hybrid structure leading to these potential benefits, we constructed a hypothetical portfolio which weighted the common equity securities within the Wells Fargo Hybrid and Preferred Securities Index as of December 31, 2017 based on the ultimate parent issuers weight. The portfolio then held these stocks for one year with no rebalancing. We acknowledge that the measure of preferred shares rebalances and the composition may have changed throughout the year due to that rebalancing, but those minor differences should not subsume the results—which are startling.3
While both the preferred shares and the hypothetical portfolio declined, losses in the hypothetical portfolio were nearly triple the losses seen in preferreds (-14.74% vs. -4.57%). Standard deviation was also considerably disparate: The hypothetical portfolio’s volatility was three times greater than that of the preferreds (14.80 vs. 4.53). Lastly, the maximum drawdown of the hypothetical portfolio was 2.5 times greater than the preferreds (-22.68% vs. 8.48%). What’s even more interesting is that the correlation between the two portfolios last year was just 0.22. Acknowledging the relatively small sample size (1 year), if we use that correlation figure to determine the coefficient of determination, R-Squared—which is used to analyze how differences in one variable can be explained by a difference in a second variable—we can estimate that only 5% of (0.22 ^ 2) the preferred shares returns over the past year can be explained by the movement in the underlying common stocks returns. This underscores the unique nature of preferred shares.
Key takeaway: Due to the hybrid nature of preferred shares, the volatility profile is lower than that of common stocks—both traditional US large caps and the actual underlying common stocks of the same preferreds—and credit-sensitive high yield bonds. Therefore, combined with the aforementioned low correlations, preferreds may be able to lower the overall volatility profile of the entire portfolio.
For investors seeking an attractive source of income in portfolios, they should take a close look at preferreds. We believe they represent an appealing means to capturing additional yield while also potentially improving diversification and reducing overall portfolio volatility. For these reasons, we include it as one of the strategic asset classes within our income allocation fund, (INKM), holding the SPDR® Wells Fargo® Preferred Stock ETF (PSK) at a 5% weight.
175% of the Wells Fargo Hybrid and Preferred Securities Index is rated within the investment grade space, per Bloomberg Composite Ratings.
2Bloomberg Finance L.P. as of 03/01/2019.
3FactSet, as of 12/31/2018. The rationale for weighting the hypothetical portfolio by issuers was to closely resemble to the gauge of preferred stocks.
Measures the volatility of a security or portfolio in relation to the market, usually as measured by the S&P 500 Index. A beta of 1 indicates the security will move with the market. A beta of 1.3 means the security is expected to be 30% more volatile than the market, while a beta of 0.8 means the security is expected to be 20% less volatile than the market.
Bloomberg Barclays High Yield Very Liquid Index
The Barclays High Yield Very Liquid Index is designed to measure the performance of publicly issued U.S. dollar denominated high yield corporate bonds with above-average liquidity. Denominated high yield corporate bonds with above-average liquidity.
Bloomberg Barclays US Aggregate Index
A market-weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Most US traded investment grade bonds are represented. Municipal bonds and Treasury Inflation-Protected Securities are excluded, due to tax treatment issues. The index includes Treasury, Government agency bonds, Mortgage-backed bonds, Corporate bonds and a small amount of foreign bonds traded in the US.
Bloomberg Barclays US Aggregate Credit Investment Grade Index
The Index is designed to measure the performance of the investment grade corporate bond market. The Index includes publicly issued, investment grade, fixed-rate, taxable, U.S. dollar-denominated corporate bonds issued by U.S. and non-U.S. industrial, utility, and financial institutions.
Bloomberg Composite Rating
A blend of a security's Moody's, S&P, Fitch, and DBRS ratings. The rating agencies are evenly weighted when calculating the composite. The Bloomberg Composite is the average of existing ratings, rounded down to the lower rating if the composite is between two ratings.
The historical tendency of two investments to move together. Investors often combine investments with low correlations to diversify portfolios.
An investment’s largest loss from a peak to a trough over a certain time period.
A statistical measure of how close the data are to the fitted regression line. It is also known as the coefficient of determination, or the coefficient of multiple determination for multiple regression. 0% indicates that the model explains none of the variability of the response data around its mean.
S&P 500 High Dividend Index
Measures the performance of 80 high yield companies within the S&P 500 and is equally weighted to best represent the performance of this group, regardless of constituent size.
S&P 500 Index
The S&P 500, or the Standard & Poor’s 500, is an index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices.
A measure for calculating risk-adjusted returns that has become the industry standard for such calculations. It was developed by Nobel laureate William F. Sharpe. The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. The higher the Sharpe ratio the better.
A statistical measure of volatility that quantifies the historical dispersion of a security, fund or index around an average. Investors use standard deviation to measure expected risk or volatility, and a higher standard deviation means the security has tended to show higher volatility or price swings in the past. As an example, for a normally distributed return series, about two-thirds of the time returns will be within 1 standard deviation of the average return.
Wells Fargo Hybrid and Preferred Securities Index
A modified market-capitalization-weighted benchmark designed to measure the performance of non-convertible preferred stock and securities that are equivalent to preferred stock. Constituents include depositary preferred securities, perpetual subordinated debt and some securities issued by banks and other financial institutions that are eligible for capital treatment.
The income produced by an investment, typically calculated as the interest received annually divided by the investment’s price.