Lance McGray is Managing Director and Head of ETF Product at Advisors Asset Management responsible for the creation and execution of AAM’s ETF business.
Russ Alan Prince: Your Low Duration Preferred & Income Securities ETF is approaching its 3-year anniversary. What are the characteristics of preferred and hybrid securities?
Lance McGray: Preferred and hybrid securities are a type of hybrid investment that exhibit characteristics of both fixed income and equity securities. Like traditional bonds, they offer a fixed or floating dividend, similar to a bond’s coupon. Like common stock, they represent ownership in the company and have the potential to appreciate or decline in price.
In a corporation’s capital structure, preferred securities fall between corporate bonds and common stock. Given the generally rank below a corporation’s bonds, they can carry a relatively lower credit rating. Accordingly, preferred securities offer higher yields than those of investment-grade corporate bonds, as preferred investors are compensated for the potential added credit risk. However, given preferred securities also rank above a corporation’s common stock, investors of preferred securities take priority over common stockholders with respect to a claim on a company's assets in the event of bankruptcy or liquidation.
Preferred securities generally carry par values of $25 and are exchange-traded, making them more accessible to the retail investor. However, there are preferreds that are issued with $1,000 par values to cater more to the institutional investor. Preferreds can also have embedded call features and reset features, designed to allow the issuing corporation to redeem the securities or reset interest rates in response to market conditions.
Prince: What role do low-duration preferreds play in a portfolio?
McGray: Most commonly, preferred securities are sought by investors seeking higher income than those generated by traditional fixed income investments. Due to their position in the capital structure, preferred securities can offer higher yields than US treasuries, municipals, and investment-grade corporates. As a result, preferreds can help increase overall portfolio yield.
However, preferreds can also carry maturities several years into the future, or in many cases no maturities at all which are referred to as perpetual preferreds. This can expose investors to elevated levels of interest rate risk. Instead, low-duration preferred securities can be a better alternative for preferred investors.
Given the call and reset features often embedded into preferreds, looking at options-adjusted durations can more accurately measure and help manage interest rate risk. Accordingly, by targeting preferreds with option-adjusted durations of less than 5 years, our portfolio of low-duration preferreds strikes a balance between maximizing yield and minimizing interest risk.
Moreover, low preferred securities can offer portfolio diversification away from equities that are not offered by traditional bonds. Given their hybrid nature, preferred securities have exhibited low historical correlations to traditional stocks and bonds, which may help reduce portfolio volatility and mitigate downside risk.
Finally, not only do preferreds offer attractive yields, compared to other income-producing securities, they do so in a tax-efficient manner. Many preferreds pay qualifying dividend income, which is generally taxed at long-term capital gains rates instead of higher ordinary income rates. This favorable tax treatment can be very beneficial for tax-sensitive investors.
Prince: What about today’s market environment makes them an attractive asset class?
McGray: As we believe we are at the beginning of secular regime change largely driven by higher interest rates, duration management will continue to be a top priority for fixed-income investors. While it is enticing to extend duration in order to attain higher yields, it can be detrimental to a portfolio during a rising interest rate environment.
As interest rates continue to rise, bond values will continue to decline. This dynamic unfolds even more rapidly for higher-duration securities, such as conventional preferred securities. At the same time, positioning a portfolio towards extreme short duration comes with significantly lower yields as well. For this dilemma, low-duration preferred securities are an attractive asset class. Through our focus on preferred securities with option-adjusted durations of 5 years or less, low-duration preferreds as an asset class can help reduce interest rate risk without sacrificing yield.
Despite their lower durations, low-duration preferred securities are still able to offer higher yields due to their unique position in a corporation’s capital structure. Moreover, as interest rates rise, low-duration preferreds can more effectively insulate investors from declining bond values while also preserving their higher yields.
RUSS ALAN PRINCE is the Executive Director of Private Wealth magazine (pw-mag.com) and Chief Content Officer for High-Net-Worth Genius (hnwgenius.com). He consults with family offices, the wealthy, fast-tracking entrepreneurs, and select professionals.