These high-yielding assets tend to do well in rate cutting cycles
As investors await the Federal Reserve’s first rate cut, those who are seeking income may want to consider preferred securities, according to a Bank of America analysis. The assets, which can have yields of roughly 6%, are a hybrid product that trade on exchanges like stocks but have par values and pay income like bonds. When the value of a preferred goes up, yields go down. Preferreds have done well in the weeks heading into the last four Fed rate-cutting cycles, strategist Michael Youngworth said in an Aug. 6 note. Those that were fixed rate and had $25 par values did particularly well. Preferreds are also available in $1,000 par values. “Preferreds have logged among the best average returns on a cross-asset basis, trailing only the S & P 500, into the first cut,” he said. “Though risk-asset returns have typically cooled in the weeks after the first Fed rate cut, preferreds still have fared well versus peers, though they underperformed alongside stocks after the first cut of the September 2007 [Global Financial Crisis] cycle (a hard landing).” The central bank’s next two-day meeting begins Sept. 17. Fed funds futures pricing data suggests a 100% likelihood of rate cut at that time, according to the CME FedWatch Tool . In July, Fed Chair Jerome Powell said that a September rate cut is ” on the table .” Economists are expecting the central bank will achieve a soft landing . Solid income and favorable credit quality UBS also finds certain preferred securities attractive right now. The firm’s list is based on those who have favorable fundamental credit quality, valuation and structure. “To mitigate rate and spread volatility we favor preferreds that pay relatively high fixed coupons,” UBS senior fixed income strategist Frank Sileo wrote in an Aug. 7 note. Here are some fixed-rate names that made the cut. Bear in mind that preferreds often have a call date, which is when the issuer can redeem them. These instruments also have greater credit risk, as investors in preferred securities are subordinate to bondholders in the event an issuer falls on hard times. Like many other fixed income instruments, preferreds have been enjoying attractive yields. The ICE BofA Fixed Rate Preferred Securities index, which tracks the performance of fixed-rate preferred securities, has a yield-to-worst of 5.86%. That’s above the 10-year average of 4.2%, said JR Humphreys, senior portfolio manager with Sheaff Brock Investment Advisors in Indianapolis. He noted that yield-to-worst — a measurement of the minimum amount of yield an investor can expect to earn — is the best barometer for preferreds. He’s bullish on preferreds, which he owns in the funds he manages. Humphreys said interest rate cuts will be a tailwind for the securities. In addition, the biggest issuers are financial institutions and insurance companies, he said. “They have so much regulatory oversight that it adds a level of comfort,” he said. Tackling the preferreds market through ETFs For those who want to invest in preferreds, Humphreys recommends buying an actively managed mutual fund or exchange-traded fund. “The preferred market is very inefficient,” he said. “It’s not like a stock where you can look at a set of parameters and get some type of valuation. Each preferred issue may have different payouts and callable features.” Here are some preferred securities ETFs. If buying individual preferreds, it’s important to be diversified among different issuers, Humphreys said. He also suggests buying discounted preferreds on the secondary market. That’s because with interest rates expected to go lower, the value of the security should start to rise. “If rates come down, that [$25 par value] preferred will go up some and at a point it will move sideways, even as rates continue down,” he said. “It will be called at $25 one day.” If you buy one that trades at $20, it can go up to $25 and keep going up a couple more points, he said. “You get to participate on the yield down/price up to a greater amount,” he said. Richard Alt, CEO of Carnegie Investment Counsel in Pepper Pike, Ohio, also rarely buys a new issue preferred since there are so many trading at a discount. That said, he only buys them for a handful of clients who need to boost their income. The assets are thinly traded and are typically not included in large funds, he noted. The downside of preferreds is that if the underlying company’s stock does well, the security doesn’t participate in the upside. Plus, if a company goes belly up, bondholders have more rights to claiming payment than preferred holders, Alt said. Investors should also be aware that the direction of interest rates and the economy matter to the performance of preferreds, he said. You should be confident that interest rates are going to fall and that the economy will not dip into a recession, he noted. If those boxes are checked, he thinks preferreds could be a good asset for investors who want to clip coupons. “If you don’t care about share price and the company is solid, you are probably going to be fine,” Alt said.
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