Why to Consider Preferred Securities Now

Preferred securities prices have fallen sharply, presenting an attractive entry point for income-oriented investors who can ride out the volatility. Some caution is warranted, however, and we do think prices can fall modestly from here, given the heightened risks.

What risks? Well, the Federal Reserve has officially begun its rate hike cycle and the situation in Russia and Ukraine is weighing on sentiment, pulling down the prices of nearly all risk assets. In other words, we’re not calling a bottom. But for investors who have been frustrated by the low yields since the Fed dropped rates to near zero in 2020, this has presented an opportunity to lock in higher yields.

Yields up, prices down

Preferred security yields have risen sharply as their prices have plunged this year—the average yield-to-worst of the ICE BofA Fixed Rate Preferred Securities Index is now close to 5%, compared to its 10-year average of just 3.9%. That’s up sharply compared to the last and a half; from July 2020 through December 2021, the average yield of the index was generally below 3%.

The drop in price was driven by the double whammy of higher long-term Treasury yields and falling stock prices. Because preferred securities are hybrid securities that share characteristics of both stock and bonds, they are influenced by both markets. The average price of the ICE BofA Fixed Rate Preferred Securities Index is now roughly $96, well below its recent peak of $108 in July 2021. While the price plunge may spook investors that currently hold preferreds, we think the entry point is looking more attractive.

Over the last 20 years, the average price of the index has rarely been lower than where it is today. There are two clear outliers: the 2008-2009 financial crisis and the pandemic-induced plunge in March 2020. Note that the chart below is truncated at $80 to illustrate where today’s price sits relative to non-crisis periods.

Over the last 20 years, prices haven’t fallen much below current levels

Source: Bloomberg, using weekly data as of 3/22/2022. Y axis is truncated at $80 for scale; the actual low was $38.60 on 3/6/2009. Note that average price of the preferred index is rebased to $100, despite many of its underlying holdings having par values of $25. As a result, the price fluctuations of $25 par value preferreds wouldn’t likely be as large in dollar terms, but would be similar in percentage terms.) Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no guarantee of future results.

The price decline has resulted in one of the worst starts to a calendar year for the ICE BofA Fixed Rate Preferred Securities Index—the index is down 7.9% through March 22nd. That’s the second worst start to a year since 2010, trailing only the 2020 pandemic-induced plunge when the index dropped more than 20% early in the year.

Preferred securities are down sharply so far this year

Source: Bloomberg. Total returns from 12/31/2021 through 3/18/2022. U.S. Aggregate Index = Bloomberg U.S. Aggregate Bond Index (LBUSTRUU Index); Investment Grade Corporates = Bloomberg U.S. Corporate Bond Index (LUACTRUU Index); High-Yield Corporates = Bloomberg U.S. Corporate High-Yield Bond Index (LF98TRUU Index); Preferred Securities = ICE BofA Fixed Rate Preferred Securities Index (P0P1 Index); and Bank Loans = the S&P/LSTA Leveraged Loan Index (SPDAL Index). Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no guarantee of future results.

One way to combat interest rate risk with preferreds is by considering variable-rate or adjustable-rate preferreds. These preferreds either have floating coupon rates, or are structured as fixed-to-float, meaning that they begin with a fixed coupon rate and then after a specified amount of time has passed, they reset based on a short-term reference rate. A benefit of these types of preferreds is that they can reduce the interest rate risk and help limit the price declines if interest rates continue to rise. They aren’t insulated from all risks though—they still have credit risk just like fixed-rated preferreds. But the lower interest rate risk has helped them outperform traditional preferreds since the beginning of 2020.