A Preferred Securities ETF Could Help Generate Attractive Yields, Diversify a Portfolio | ETF Trends

Income-minded investors who are looking for another yield-generating idea can consider the potential benefits of preferred securities and a related exchange traded fund.

In the recent webcast, Balancing Yield and Risk with Preferred Securities, Rick Baker, managing director of the client portfolio management team, Manulife Investment Management, explains what preferred securities are. Preferred securities are a class of stock or hybrid debt entitling the investor to certain preferential treatment. Preferred investors have priority claims to payment of dividends and in the liquidation of company assets over the issuer’s common shareholders. Similar to bonds, preferred securities come with coupon payments, maturity dates, stated par values, and some have callable features. Additionally, like stocks, preferreds come with non-voting rights share ownership.

Baker also notes that investors will like preferred securities’ favorable yields, low default rates, low duration risk, low correlations to traditional assets, and low sensitivity to interest rates and exposure to high-quality companies.

Preferred securities serve as an important source of regulatory capital, particularly for financial institutions such as banks and insurers after the global financial crisis, as certain preferred securities are categorized as AT1 capital.

Preferred securities serve as a lower cost option for financing as investors’ return demand is lower, and the issuance avoids common equity ownership dilution. By receiving “equity treatment” from rating agencies, preferred securities help issuers maintain their ratings and can lower debt servicing costs. In some cases, hybrid debt securities may be more attractive than traditional preferred securities for tax purposes.

Issuers prefer preferred securities as deferred payment of interest, or dividends do not create a default event, while embedded call options provide flexibility.

Preferred securities also present as an untraditional income source for investors who are chasing yields.

“With increasing market volatility and rising inflation, investors are seeking for stable and higher income assets. Preferred securities can offer a combination of attractive yield characteristics, inflation-hedging potential and interest rate risk mitigation,” Baker says.

“As an investment-grade asset class, yields of preferred securities are comparable to those of high yield bonds, meaning investors can enjoy similar yields with relatively less credit risk,” Baker adds.

Preferred security issuers are mainly large and highly regulated institutions including banks, insurance companies, utilities, and communications. The average credit rating of preferred securities is BBB-, or a lower investment grade.

Looking at the actively managed John Hancock Preferred Income ETF (JHPI), potential investors should notice a divergence in the active management’s selection style. Specifically, JHPI is more underweight in the financial sector, especially exposure toward broad financial companies, and the fund is most overweight to utilities companies.

Baker argues that the outlook of the U.S. economy is positive with support from both monetary and fiscal policy. This is positive for the preferred securities market when credit spreads should remain stable. The average credit rating of preferred securities is BBB-, an investment-grade rating, and over 97% of preferred issuers are rated as investment-grade.

“We think that very few, if any, preferreds will default in 2022, but historical default rates among preferred securities have been low primarily because issuers are generally well-established, high-quality companies with solid balance sheets,” Baker says.

Preferred securities should also do relatively well in a rising rate environment. Baker pointed out that in the past rising rate environment, preferreds performed well given the extra carry relative to other areas of fixed income.

For those interested in the preferred securities space and are looking at something like the John Hancock Preferred Income ETF, Joseph Bozoyan, portfolio manager, Manulife Investment Management, explains that the actively managed strategy is backed by Manulife IM, a U.S.-based lead manager with more than 29 years of investment experience and an established track record. It is also one of the key players in the preferred securities market in terms of assets under management.

“We believe that a portfolio of high-quality securities with above-average yields can generate high income and protection of capital. We seek an enduring business model, strong balance sheets, sustainable free cash flow, stable and/or growing dividends, solid management teams that are stewards of capital allocation, and deep fundamental credit research with the integration of environmental, social, and governance (ESG) considerations,” Bozoyan states.

Financial advisors who are interested in learning more about preferred securities can watch the webcast here on demand.