Investors seeking yield-generating opportunities should also consider the benefits of preferred securities and a targeted preferred income exchange traded fund strategy.
In the upcoming webcast, Seeking stable cash flow in today’s market, Rick Baker, managing director of the Client Portfolio Management Team at Manulife Investment Management, explained that 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 and share ownership.
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.
Lastly, preferred securities are also an untraditional income source for investors chasing yields.
Baker added that 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.
Baker also argued that investors should now pay attention to preferred securities because of the favorable yields, low default rates, low duration, and lower interest rate sensitivity.
As a way to help investors capture this market segment, Baker highlighted 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. The ETF has the flexibility to invest in all types of preferreds and is based on deep fundamental research.
Joseph Bozoyan, portfolio manager at Manulife Investment Management, explained the philosophy behind their investment methodology.
“We seek to achieve an informational advantage over peers by leveraging MIM’s extensive network of portfolio managers and research analysts, along with our trading team, to construct a preferred income portfolio. We invest in companies with enduring business models, strong balance sheets, sustainable free cash flow, stable or growing dividends, and solid management teams that are stewards of capital,” Bozoyan said.
Specifically, Bozoyan argued that mispriced securities always exist, so extensive fundamental research can uncover these opportunities, and opportunities exist up and down a company’s capital structure.
Bozoyan explained that the John Hancock Preferred Income ETF strategy’s dynamic asset allocation approach is based on each sector’s risk, return, quality, and yield characteristics relative to each other, resulting in a unique approach to preferred securities allocations.
“We believe utility fundamentals are excellent, and they offer attractive yields,” Bozoyan said.
“We believe financial services companies are well positioned from a balance sheet standpoint. U.S. banks are strong, well-capitalized, with good liquidity, and bank balance sheets are in the best shape in over 20 years.”
Consequently, investors can incorporate preferreds as an alternative to credit-sensitive fixed income sectors, according to Bozoyan, as the asset category offers attractive risk-to-return profiles, tax-efficient yields, diversification, low interest rate risk, and a higher quality focus.
Ryan Wellman, product manager at John Hancock Investment Management, pointed out that compared to other traditional fixed-income segments, preferred securities have outperformed credit-sensitive fixed income sectors on an absolute and risk-adjusted basis, with preferreds exhibiting exhibiting a 10-year Sharpe Ratio of 0.64, compared to the 0.23 for U.S. Core Bonds or the 0.44 for High Yields.
Wellman also underscored preferreds high and tax-efficient nature. Unlike traditional fixed income distributions, which are taxed as ordinary income, preferred securities distributions are typically taxed as qualified dividend income.
In addition, Wellman noted that preferreds provide diversification through low correlations to equities and high-quality bonds, and the asset has lower interest rate sensitivity and higher credit quality as well.
Financial advisors interested in learning more about preferreds can watch the webcast here on demand.