This article was written by Invesco PowerShares Senior Fixed & Equity Income Product Strategist Josesph Becker.
With the Federal Reserve (Fed) ending its third and final round of quantitative easing (QE) in October, investors are trying to assess the impact on income-producing asset classes. While the complete effect of Fed policy normalization remains to be seen, the end of its asset purchases effectively eliminates the downward pressure that balance-sheet growth has put on rates.
Additionally, the end of QE leaves the Fed one step closer to its next phase of policy normalization, which may well involve raising the federal funds rate. Against this backdrop, the prospect for rising rates comes more into focus, prompting investors to examine the rate risk embedded in their preferred stock exposure.
Preference for preferreds
In the face of below-average interest rates over the last several years, investors have increasingly looked beyond traditional fixed income instruments in an effort to generate the yields they were able to earn before the Great Recession. One market segment that has benefited is preferred stock, which typically generates higher yields than bonds due to their lower position in the capital structure—and their income is often tax-advantaged. In fact, assets in preferred stock funds have grown from $1 billion to more than $10 billion over the last 10 years.1
During the latter half of this period, Fed intervention in the bond market via QE has been supportive of preferreds, which have traditionally had fixed coupons and long maturities. Since the beginning of the first round of QE in February 2009, preferreds have generated an annualized return that slightly underperformed stocks but generated more than three times the return of bonds, as shown below.
Investors got a brief taste of the effect of rising rates on preferreds last year during the market’s “taper tantrum,” when the Fed announced plans to reduce its asset purchases and kicked off a rise in Treasury yields. As seen below, rates began to rise in May. By the time they peaked in September, the prices of fixed-rate preferreds had fallen more than 10%.2
Investors eyeing variable-rate preferreds
As preferred stock investors make adjustments to reduce the risk that their bonds will decline in value in the event of an interest rate rise, variable-rate preferreds — including both floating-rate and fixed-to-floating rate preferreds —are getting increased attention.