Preferred Securities: Income Opportunity Amid Falling RatesCoulter Regal, CFA, Associate Product ManagerNovember 20, 2019
The Federal Reserve approved another quarter-point interest rate cut during their latest meeting in October, marking the third rate cut this year. In this type of low rate environment, many investors are searching for yield beyond traditional debt, leading to increased interest in other income producing assets such as preferred securities In this Q&A, we answer some common questions about preferreds and discuss what sets the VanEck Vectors Preferred Securities ex Financials ETF (PFXF) apart from the broad preferreds universe.
How do yields for preferreds compare to other asset classes?
Historically, a company’s preferred securities have offered higher yield than its common stock or senior debt. However, with traditional financial companies saturating the market, this traditional scenario is not playing out the way it once had. Targeting preferred securities ex-financials may provide investors with a yield premium, most effectively spent allocating to the broad preferred market in aggregate.
Yields Across Asset Classes
Source: FactSet. As of 10/31/2019. Yields presented are current yields (ratio of the annual interest payment and the security’s current price), except for Equities’ dividend yield (dividend per share, divided by the price per share). Equities is represented by the S&P 500® Index, High Grade Corporate Bonds represented by the ICE BofA Merrill Lynch US Corporate Index, Preferred Securities represented by the Wells Fargo® Hybrid and Preferred Securities Aggregate Index, Preferred Securities ex Financials represented by the Wells Fargo® Hybrid and Preferred Securities ex Financials Index and High Yield Bonds represented by the ICE BofA Merrill Lynch US High Yield Index.
Why exclude traditional financial companies?
After the financial crisis of 2008, banks began issuing a significant amount of preferred stock to meet the higher capital levels required by regulators. This proliferation of preferreds issuance by financials has led to an over concentration of the sector, which now makes up over 70% of the U.S. preferred market.1 Excluding traditional financial companies results in a more diverse sector exposure, relative to the broad preferreds market, and may help reduce sector concentration risk without sacrificing yield. Beyond increased sector diversification, excluding financial issuers also increases the proportion of preferreds paying cumulative distributions in the index and lowers the proportion featuring near-term call dates.
Source: FactSet. As of 10/31/2019. Based on the Wells Fargo® Hybrid and Preferred Securities Aggregate Index and the Wells Fargo® Hybrid and Preferred Securities ex Financials Index.
What are cumulative distributions?
The cumulative feature of some preferred issues stipulates that deferred distributions be paid in full before distributions are paid to common stock shareholders. Financial companies primarily issue non-cumulative securities for capital requirement reasons. As of October 31, 2019, 32% of preferred securities featured cumulative distributions compared to 66% of preferred securities ex-financials.2
How concerned should I be with call risk?
Most preferred issues are callable, which introduces both reinvestment risk (i.e., reinvesting at lower rates than the called issue) and risk of loss if the issues were purchased at a premium to the call price. While most financial preferreds are callable, far more are callable in the near term than those issued by companies outside of traditional financial industries. Excluding or reducing financials can reduce call risk to your portfolio.
Callable Callable by 2020 Callable by 2023 Callable by 2025 Financial Preferreds 100% 31% 71% 93% Preferreds ex Financials 76% 21% 55% 74%
Source: Bloomberg, Wells Fargo. As of 10/31/2019. Financial Preferred Securities represent the Wells Fargo® Hybrid & Preferred Securities Financial Index. Preferred ex Financials Securities represent the Wells Fargo® Hybrid & Preferred Securities ex Financials Index. For illustrative purposes only.
How do preferred securities fit into a portfolio?
For investors seeking yield in the current low rate environment, preferred securities can potentially offer increased income generation within a portfolio. In addition, their low correlations with equities and traditional fixed income instruments can make them a useful diversifier in portfolios. Preferreds can serve as a complement to a portfolio’s core fixed income allocation alongside or in place of high yield debt.
Preferreds 5-Year Correlations
1 2 3 4 5 Preferreds ex Financials 1.00 U.S. High Yield 0.69 1.00 U.S. High Grade Corporate 0.59 0.43 1.00 U.S. Equities 0.52 0.71 0.15 1.00 Short-Term U.S. Treasury 0.18 -0.07 0.68 -0.33 1.00
Source: Morningstar. As of 10/31/2019. Preferreds ex Financials is represented the Wells Fargo® Hybrid and Preferred Securities ex Financials Index, U.S. High Yield by The ICE BofA Merrill Lynch US High Yield Index, U.S. High Grade Corporate by the The ICE BofA Merrill Lynch US Corporate Index, U.S. Equities by the S&P 500® Index and Short-Term U.S. Treasury by the Bloomberg Barclays 1-3 Yr US Treasury Index.
PFXF seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the Wells Fargo® Hybrid and Preferred Securities ex Financials Index (WHPSL). WHPSL is a rules-based index designed to track the performance of convertible or exchangeable and non-convertible preferred securities, issued by U.S. or foreign issuers that are not financial services companies or banks and that are listed on U.S. national securities exchanges.
1Source: S&P U.S. Preferred Stock Index (SPPREF). As of 10/31/19.
2Source: Bloomberg. Financial Preferred Securities represent the Wells Fargo® Hybrid & Preferred Securities Financial Index. Ex-Financials Preferred Securities represent the Wells Fargo® Hybrid & Preferred Securities ex Financials Index. As of 10/31/19.
This is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.
The Wells Fargo® Hybrid and Preferred Securities Aggregate Index (WAGG) is designed to track the performance of non-convertible, $25 par preferred securities listed on U.S. exchanges. The index is composed of preferred stock and securities that, in Wells Fargo’s judgment, are functionally equivalent to preferred stock.
The Wells Fargo® Hybrid and Preferred Securities ex Financials Index (WHPSL) is a rules-based index designed to track the performance of convertible or exchangeable and non-convertible preferred securities, issued by U.S. or foreign issuers that are not financial services companies or banks and that are listed on U.S. national securities exchanges.
Wells Fargo® Hybrid and Preferred Securities Financial Index (WHPSF) is a rules-based index designed to track the performance of convertible or exchangeable and non-convertible preferred securities, issued by U.S. or foreign issuers that are financial services companies or banks and that are listed on U.S. national securities exchanges.
The ICE BofA Merrill Lynch US Corporate Index (C0A0) is comprised of investment grade corporate bonds (based on the index providers proprietary composite of various rating agencies) denominated in U.S. dollars.
The ICE BofA Merrill Lynch US High Yield Index (H0A0) is comprised of below-investment grade corporate bonds (based on the index providers proprietary composite of various rating agencies) denominated in U.S. dollars.
The S&P 500® Index (SPX) consists of 500 widely held common stocks covering industrial, utility, financial and transportation sector; as an Index, it is unmanaged and is not a security in which investments can be made.
The S&P U.S. Preferred Stock Index (SPPREF) is comprised of U.S. traded preferred stocks that meet criteria relating to minimum size, liquidity, exchange listing, and time to maturity.
The Bloomberg Barclays 1-3 Yr US Treasury Index (LT01TRUU) is a rules-based, market-value weighted index engineered to measure the performance and characteristics of fixed rate coupon U.S. Treasuries which have a maturity greater than 12 months and less than 36 months.
The VanEck Vectors® Preferred Securities ex Financials ETF (PFXF®) is not sponsored, endorsed, or advised by Wells Fargo & Company, Wells Fargo Securities, LLC (together, “Wells Fargo”), Index Calculation Agent, NYSE Arca, or any of their subsidiaries and affiliates. WELLS FARGO AND INDEX CALCULATION AGENT DO NOT GUARANTEE THE ACCURACY AND/OR COMPLETENESS OF ANY DATA SUPPLIED BY THEM OR OF THE INDEX UNDERLYING THE ETF AND MAKE NO WARRANTY AS TO THE RESULTS TO BE OBTAINED FROM INVESTING IN THE ETF OR IN THE INDEX.
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Authored byCoulter Regal, CFA
Associate Product Manager