Market volatility often creates opportunities. We previously discussed the advantages in the current market environment of considering “strategic income” securities as part of a portfolio’s fixed income allocation. Narrowing in on that category further, we believe that, due to the underperformance that preferred securities have experienced year-to-date and over the past 12 months, it may be a good time to consider adding exposure to that asset class at these attractive levels.
For those unfamiliar, preferred securities are a fairly unique asset class that contains features of both stocks and bonds and are typically considered part of a fixed income allocation. Preferred stock is a form of equity that pays dividends, but those dividends are more like an interest payment on a bond. Unlike bonds, however, many of the dividends paid by preferred stock are qualified dividends (QDI), meaning they are tax-advantaged and taxed at just 20%, plus the 3.8% Medicare surcharge for top earners, instead of the ordinary income tax rate typically associated with bonds. Many companies issue preferred stocks, though the market is dominated by financial companies such as banks, insurance companies and real estate companies. Utility companies also often issue preferred stock.
In today’s landscape, preferred securities offer attractive yields as compared to other fixed income asset classes. When adjusted for the tax advantage that most preferred securities provide, the yield advantage becomes even more attractive in the current market environment.
Current Fixed Income Yields
Since preferred securities provide features of both debt and equity, they typically exhibit lower correlation to both traditional bonds and equity securities. We’ll often see lower-correlation asset classes used as a tool to improve overall portfolio diversification. A correlation of +1 implies a perfect correlation, meaning that the two securities being compared move in the same direction as each other. A correlation of -1 implies a perfectly negative correlation, meaning two securities move in the opposite direction of each other. The five-year correlation of preferred stocks with the equity market and traditional corporate bonds is about 0.5, meaning they will generally move in the same direction as each other, but some diversification benefit may be gained.
5-Year Correlation
Historically, we have seen that preferred securities may even provide higher returns than traditional fixed income asset classes. The returns shown in the following table are not adjusted for the tax differentials that preferred securities and municipal bonds can benefit from.
At Ancora, our investment professionals meet regularly to discuss capital markets assumptions, the economic environment and various tools and approaches that may be more attractive given macro factors. With the recent market volatility, we believe that preferred securities may offer an attractive entry point for fixed income portfolios seeking to increase yields while maintaining a higher-quality fixed income exposure. Be sure to speak with your advisor to discuss your overall portfolio allocation and whether any strategic adjustments may be appropriate.