AAM Viewpoints: Preferreds Offering Material Value Following Perfect Storm
2018 was a challenging year for many asset classes including preferred securities, which experienced its first negative year since 2008. For the year, preferreds declined 4.2% with the majority of those losses occurring in the fourth quarter of the year. The fourth quarter was a period that really felt like the preferred market was hit with a perfect storm of events.
There were concerns for softer global economic growth, questions surrounding the future path of U.S. fed policy, continued volatility in the headlines pertaining to Brexit. We were also dealing with trade wars. The asset class itself saw significant outflows, largely attributed to tax-loss selling later in the quarter.
While these issues and concerns don't get erased for just the flip at the calendar, we do believe a lot of the negative is priced into the preferred market today. For investors who are able to whether a little bit of volatility here in the short run, we do believe preferreds offer an attractive investment opportunity due to the potential for high income, good relative value and diversification benefits the asset class currently provides.
From an income standpoint, in index of investment grade preferred securities is yielding 6.2%. We haven't seen that level of income in this asset class since December 2013, which was the tail end of the taper tantrum. In addition, for U.S. investors they should be reminded that a large portion of preferred income will be treated as qualified dividend income, meaning higher after-tax income as well.
When looking at value in the preferred market versus other areas of fixed income, we can look to yield spreads. Currently, the preferred market is yielding 355 basis points more than the U.S. 10-year Treasury. To put that in some context, prior to the financial crisis, the preferred market averaged at 225 basis point advantage over the U.S. 10-year Treasury.
Similar statements can be made today of preferreds versus high yield as well as investment grade corporates. From a diversification standpoint, preferreds offer low correlation stocks and bonds. In addition, the issuer makeup of the preferred market can provide further diversification. The preferred market is made up largely of issuants from banks and insurance companies as well as other regulated industries and those that provide stable cash flows, such as utilities, telecom and REITs (real estate investment trusts). In contrast, the high-yield market is made up of largely more cyclically oriented issuers such as energy and basic materials.
Considering the meaningful risks priced in the preferred market today, in addition to the high level of income, good relative value and diversification benefits we feel the asset class offers, we believe 2019 will be a strong year for preferred securities.
Opinions in this piece are those of Cohen & Steers and are not necessarily that of Advisors Asset Management (AAM).
An investment in preferred securities should be made with an understanding of the various risks of owning preferred securities such as an economic recession, volatile interest rates and the possible deterioration of either the financial condition of the issuers of the preferred securities or the general condition of the stock market. Preferred securities do not generally have the growth potential of common stocks. They are also sensitive to changes in interest rates and their market prices generally fall with rising interest rates. Preferred securities are more likely to be called for redemption in a declining interest rate environment. In addition, in the event of an issuer's bankruptcy, preferred securities will not be repaid until the issuer's other debt securities, which have priority, have been satisfied. Preferred securities are equity securities of the issuing company which pay income in the form of dividends.
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.