What do you, or others, think about getting into preferreds now (given current prices)? I’ve got money on the side but not enthusiastic about anything I’m seeing out here, it’s depressing. That said a 6% yield on some preferred utilities with solid financials seems attractive right about now, and could be levered up. No real equity upside (how much upside is really left in the market anyhow?) BUT potential downside; rates could go up (seems unlikely in the short-term) or stocks could go down suddenly. Preferreds tend to have less volatility than stocks, but in nasty situations like 2008 it can still wipe levered people out. Anyhow, been thinking this strategy through, just don’t like the current prices…seems like they can only go down.
by fixed income, i mean preferreds and other FI securities with credit risk as well. i’d say at least half of your allocation should be prefs and HY (prefs are better) right now. you may have to be tactical with this allocation though, like you hinted.
^ Why take risk in your bond holdings? It makes no sense to me, in today’s market environment to hold 50% equity + 50% high yield instead of 75% equity and 25% bills. Take your risks in equity where you have upside. Taking risks in bonds is for fools, unless you’re in some kind of mispriced environment (which is not today, HY bonds are too expensive).
Agree 100% with Geo. I view bonds as the stabilizing mechanism for portfolios. Every day of the week I’ll take a lower yield for greater insurance that I’m getting my principal back (Federals/Prov’s). I don’t want to take equity-like risk in fixed income (especially given the depressed yields on corporates to begin with). That’s what the stocks are for.
If I’m buying a higher yield corporate, why wouldn’t I just own the stock? It obviously depends on how the company is capitalized, but the trade off just isn’t worth it in my opinion.
I agree there’s a place for preferreds but I wouldn’t want more than 10% of my overall portfolio in them because of the interest rate risk
credit anticipates, equity confirms. junk bonds have spreads are still somewhat narrow but are widening. widening trend not a good sign. But im still not worried.
But not everyone thinks there is a lot of equity upside left in the market.
this guy i kno has been crushing it in MBS, he wont take my money tho
How much more upside in equities can we possibly have?
^ Well you’ve got no upside on your bonds other than a little coupon. Relative advantages. The point of holding bonds is to diversify. Holding HY bonds which are more correlated with equities doesn’t really make sense.
Well, if in 2015 equities are flat (or mildly-up) plus some increased volatility – a preferred/HY portfolio does 6% (or levered 2X does 11%), which beats a stock portfolio. If equities go way up it underperforms, but still not a bad year. If equities go down, the fixed porfolio could very well go down also, though perhaps not as much. With ZIRP I’m not very worried about price dropping due to rates increasing, and even if rates go up, they won’t go up by much. Anyhow I’ve never considered keeping a large part of my portfolio in fixed income, but given the current situation I’m thinking about all sorts of things I don’t normally think about…
And what’s the downside on equity? And I’ve already addressed my bonds have roughly a extremely minimal correlation. I’m sure there are plenty of bonds that are similiar
Your logic thusfar is this: equity can go up and bonds can’t, so invest in equity. And you say bonds have all the downside, but don’t talk about equity downside. So even if an asset worth 20 is selling for 40, it still can go up so invest? You seem to have an aversion to fixed income for some reason and your analysis thus far has seemed rather simplistic, coming from someone who is a smart guy. There are shades of gray in upside and neutral, extreme violatility and minimal violatility. It’s not binary.
^ When I get a decent block of time in the next few days, I’ll address this. My position is more well thought out than it seems based on what I’ve written here.
On Sunday I started modeling my “2015 hover mode” strategy. Here it is illustrated in a simple two security manner, please feel free to rip it to shreds… Allocation --> 70% long S&P US Preferred Index (PFF), 30% long S&P500 (SPY), 2X leverage. After expenses the preferreds pay 6.4% (monthly payments), and levered they do 11.8% (1% borrowing cost). Collect the payments, wait for the market to figure out what it wants to do post QE. The risks I’ve identified thus far… 1) Equity market movements – PFF/SPY beta is .04, very little correlation, just the convertibles. Take the volatility a couple weeks ago as an example, had no impact on the preferreds. The exception is when the decrease in equities is due to widespread credit, see below. 2) Interest rate risk – the fed could raise rates. But preferreds are less sensitive than bonds; for example when the fed raised rates from 1% to 5% 2004-2006 PFF only suffered around 3-4% loss per year, offset by the dividends. PFF holds 45% in perpetual securities (these have the most rate risk), but other holdings have floating rates and shorter duration. Plus if the fed raises rates we can assume it is because the economy is doing well, meaning a) tightening credit spreads should offset some of the losses, and b) gains on the 30% equity allocation offsets the rest of the damage. If on the other hand equity markets go down, no rate increases, and losses on SPY are offset by the preferred dividends. 3) Credit risk – here’s the only scenario I’ve come up with where a person gets slaughtered. In a widespread credit crisis like 2008 preferreds start acting like equities and get crushed. If you are levered up, you potentially blow up! However a) we just had that recently and one would think many of the bad credits are cleaned out, b) PFF survived that extreme credit shock, if you held thru you would be okay, c) when credit news turns bad obviously you deleverage, d) and you short widening credit spreads (WYDE), or e) you exit the strategy all together. Unless it drops 40% in a single day with zero warning, you survive. 4) Industry concentration – PFF is most financials which is a problem, JNK is mostly corp industrial, and one can add individual names in preferred utilities to diversify more. There’s also emerging market corp/sovereigns (EMLC and PCY) if one wants to go crazy. Weighted avg yield ends up being around 6%. Hover mode can go on perpetually, or sell preferreds and allocate into equities later in 2015. Would Fabozzi be proud?
Excuse my ignorance, but what is the average profile of the companies in the preferred index ?
I imagine that there is considerable risk for it to yield 6% + ?
To answer your question, without further info your strategy seems quite bold to me, given the current context.
I absolutely understand the argument in being in equity, but to lever it up ?
IMO using leverage on blue chips now is asking for trouble, let alone using leverage on any corporate security that yields 6%.
HY spreads are pretty thin but look better than earlier in the year. preferred spreads, particularly in Canada still look good for many companies. you can easily get 5% with moderate duration, price stability and decent credit risk exposure. obviously, in preferreds and HYs you have to be very choosy and you have to cut your loss if the credit situation changes materially. as sovereign yeilds are historically terrible and corporate spreads are historically okay-to-attractive, investing in corporates is a no brainer. why would i invest in a tax-inefficient two year GIC/CD/sovereign at 2% when i can get a tax-efficient 5% on a two year with minimal credit risk? this 5% is a unique situation, but it exists. it is easy to find a 2.5%-3.5% on a two year in Canada with minimal credit risk. i probably wouldn’t buy ETFs for my preferred or high yield exposure.
i’m not 100% against sovereigns in general but wouldn’t want to own them for long when they yield less than inflation.
I figured this was the case. Looking forward to it
thin spreads are typically a good thing. it means junk = investment grade in yield. with the understanding that it is this way due to ppl forecasting a good economy.
That’s the interesting thing, and the important question. Preferred yields are basically the same now as pre-crisis, while many other fixed income securites are yield-screwed. There have been some changes to how these securities are structured post-crisis which might explain some of it. But to me they look quite solid, and nice yield, thus I’m trying to find the catch. With preferreds you can get investment grade (BBB) with good yields, because you are subordinate to the bonds, and because the preferred issuer can opt to skip payments. In bonds you need to go down to BIG in order to get the same yields (for example PFF and JNK are basically the same yield, but somewhat different risks). Top holdings in PFF are HSBC, Barclays, Wells Fargo, Citigroup, etc. Here’s an individual name I’m looking at; Connecticut Light & Power, issued 1968, haven’t missed a payment since 2002, BBB-, current yield 6.2%. Also John Hancock Premium Dividend Fund (PDT) is basically my strategy in a single fund “70% focused on preferreds especially high yield utilities, 30% equities”.
It’s not the same as levering up on equities though, there are risks but it’s more about fixed income risks (rates rising, or credit risk rising, and preferreds are less sensitive to rates than bonds). Anyhow I’ve been running credit/rate shock models, perhaps famous last words, but even at 2.5X leverage and massive shocks I haven’t been able to blow the portfolio up.
Yeah, I was looking at these more closely today…hard to justify going into this sector given the yields. And the price volatility was kinda crazy on some of the stuff I looked at.
Wait, does BBB- apply to the issuer or the preferred ? Does the rating even applies to preferred stocks ?
I don’t know much about preferreds, but to me they are much closer to equity than debt.
I think an interesting point would also be to see how the equity is priced if it is publicly listed…
Anyhow, it may be that a mispricing exists. It is a somehow obscure asset class ; Graham for one, did recommend not to invest in preferreds.
But in these markets ? Everybody has been chasing yields for years now, so I am sceptical of what I am reading now.
Nope, worked bond portfolios for many years, straight preferreds are definitely debt-like. Stuff like convertible preferreds respond more like equity (but those are only 6% of the US preferred index). The beta relative to the S&P500 is almost zero. But yes they are obscure hybrid securites, some with many weird features/options, and thus difficult to analyze. There are individual ratings on some preferreds, they generally get rated below the firm’s bonds.