Buying Low and Selling High is Preferred

• Moving down the capital structure may offer higher income potential as credit spreads tighten
• Lower duration strategies are better positioned to preserve capital relative to their longer duration counterparts when yields rise
• Low duration preferred securities may offer an attractive combination of high after-tax income and minimal interest rate risk

The historically low yields of 2020 forced many income-seeking investors to take on additional risk. First, they may have increased their duration exposure to capture the higher yields offered by longer-dated maturities. Or secondly, they may have migrated to “riskier” assets such as high yield corporate bonds as fiscal and monetary policy aimed to stimulate economic growth.

The tailwinds for risky assets have caused intermediate- and long-term Treasury yields to rise; a potential sign that investors are anticipating an economic recovery (or reopening). While an economic recovery is welcomed news, the current environment poses new challenges to yield seekers, and portfolios may need to be recalibrated accordingly.

Two potential ways yield seeking investors can position their portfolios for the current environment include:

1. Move further down the capital structure

The rally in risky assets dating back to the 2^nd quarter of 2020 has compressed the spread between corporate debt and Treasuries. This begs the question: where can investors find more yield? One may think an appropriate course of action is to take on additional credit risk with high yield securities. All else equal, the price of high yield debt is more sensitive to changes in credit spreads than changes in interest rates. With credit spreads as tight as they are currently, a fixed income investor may not find an appropriate level of yield compensation for their risk tolerance. An alternate approach is to move further down the capital structure.

Exhibit 1: Corporate Bond Option Adjusted Spreads
^{Source: Bloomberg | Past performance is not indicative of future results.}

This points to preferred securities as a potential solution. Preferred securities are hybrid securities that sit below secured and unsecured debt on the capital structure but above common stock. They also carry a credit rating and pay a dividend. Sitting lower than debt in the capital structure inherently means preferred securities are a riskier asset class, and, thus, often provide higher yield compensation than similarly rated bonds. In fact, preferred securities generally offer comparable yields to high yield corporate debt.

One advantage preferreds have over high yielding debt is that most preferred securities pay qualified dividends, which are taxed at a lower rate than interest income. Additionally, preferred securities are typically issued in well capitalized industries such as banks, insurance companies, utilities, telecom and REITs (Real Estate Investment Trusts), so there is potentially less exposure to the high levels of default being seen in the high yield market.

2. Rotate from high duration to low duration for capital preservation 

The long-duration strategies that benefitted investors in 2020 have introduced increased levels of interest rate risk. For the six-month period ending February 24, 2021, the 10-year Treasury yield more than doubled, rising from 0.66% to 1.44%. With higher interest rate risk, the prices of high duration assets are more volatile than low duration assets, so rising yields are a detriment to long duration assets. To potentially preserve their capital, an investor can look toward low duration strategies to potentially decrease the price volatility of their portfolios as yields may continue to rise.

Exhibit 2: Rising Treasury Yields

^{Source: Bloomberg | Past performance is not indicative of future results.}

What options do income-seeking investors have? One way to “kill two birds with one stone” is to consider incorporating low duration preferred securities into a portfolio. While preferred securities tend to exhibit high duration, there is a segment of the preferred market that contains low duration. Low duration preferreds not only have the potential to offer attractive after-tax yields relative to their traditional fixed income counterparts, but they also have the potential to offer lower interest rate risk in a rising yield environment.

Exhibit 3: Fixed Income Yield and Duration Profiles

^{Source: ICE Data Indices | Past performance is not indicative of future results.}

One of the oldest mantras investors attempt to follow is to buy low and sell high. While this feat is easier said than done, it can be applied when managing duration risk in a portfolio. As yields are climbing, it may be advantageous to incorporate low duration preferred securities in one’s portfolio for the potential for higher tax-advantaged yield and lower interest rate risk.