Why Fixed Income Investors Should Consider Preferred Security ETFs

Investors searching for yields should consider the benefits of including preferred securities exchange traded fund strategies in their portfolios.

“The question on investors’ minds is ‘How do I find income but not take on too much risk?’. We believe investors should consider preferred and capital securities. Preferreds can adapt to a changing rate environment,” Matthew Cohen, Head of Principal ETF Specialist Team, Principal Global Investors, said in the recent webcast, New Year, New Markets: The Case for Preferred Securities.

Cohen explained that preferred securities are sometimes referred to as ‘hybrids’ due to their combined debt and equity attributes. The securities are senior to common equity and junior to senior debt in the capital structure. They are issued by financial institutions, energy, utilities, and telecom companies, among others. Preferred stocks issue dividends regularly, but investors don’t usually enjoy capital appreciation on par with common shares.

“They fit between investment grade and high yield when it comes to the yield they provide and their risk characteristics. And, they provide access to qualified dividend income, an attractive quality for investors wanting to boost after-tax income. Importantly, right now, they offer an opportunity within an efficient frontier for income,” Cohen added.

In 2001, Principal acquired Spectrum Asset Management, an industry leader in preferred securities. Spectrum is one of the largest specialized managers of preferred securities in the world. They focus solely on preferred and capital securities. The team has over 30 years of experience managing across a variety of credit, interest rates, and regulatory conditions. Their conservative approach leads to higher-quality securities and is less prone to reinvestment, call, and interest rate risks. Their approach also makes them price makers, not price takers. Investors can access their expertise by investing in the Principal Spectrum Preferred Securities Active ETF (NYSEArca: PREF).

Jessica Bush, Portfolio Manager, Principal Global Asset Allocation, argued that no financial advisor is comfortable investing 100% of client assets in equities, so they will need to allocate to fixed income in some way. Consequently, advisors will have to consider capital preservation and positive real returns given the current economic and market regime.

“Even though there are risks (COVID, growth, etc.), we should be focused on delivering a return above the inflation rate right now. To do that, you have to take some risk. The questions we should always ask and answer is, ‘Am I being paid to take that risk?'” Bush said.

Bush argued that fixed income valuations currently favor preferred securities, which show spreads below their long-term average.

“We remain biased towards higher volatility spread assets. We express our preference through overweights to high yield, EM credits, and preferred securities where spreads should compress more than in investment-grade corporates,” Bush continued.

Mark Lieb, Founder, President and Chief Executive Officer, Spectrum Asset Management, also pointed out that preferred securities’ risk profile looks more like investment-grade credit based on their default rates. Consequently, preferreds offer a comparable yield to speculative-grade debt but with less credit risk than high-yield bonds.

Spectrum targets credit quality through a top-down and bottom-up process that scores relative credit quality to reduce credit risk. The firm actively manages towards lower aggregate call risk on preferred securities by reducing exposure to overpriced call options that can lead to negative yield horizons. Lastly, they focus on securities with adjustable-rate coupons and high forward reset spreads, where negative convexity is a significantly lesser risk, to help better manage interest rate risk.

Investors will commonly target high-quality, institutional $1,000 par preferred securities when investing in Principal Spectrum Preferred Securities Active ETF. The ETF seeks to enhance risk/return profiles by complementing high yield exposure and delivering tax-advantaged income potential by complementing muni exposure.