In a Rising Interest Rate Environment, Preferreds are Particularly AproposAdvice to the Advisor
“We find preferred securities attractive today from fundamental, technical and valuation perspectives,” Nuveen’s Doug Baker and Brenda Langenfeld commented back in December, citing preferred securities’ “history of lower sensitivity to rising interest rates.”
“Preferred securities are often more sensitive to changes in credit spreads than other types of bonds. So on a relative basis they may perform well during periods of gradually increasing interest rates,” the Nuveen authors explain. And, while “it may seem counterintuitive to expect an asset class with a longer duration profile to perform in a rising rate environment,” Nuveen lists two reasons preferreds might exhibit attractive relative returns if and when rates begin to rise again:
- Banks represent 75% of the preferred stock issuers. Bank profit margins improve when rates rise.
- Many preferred securities have a fixed coupon which later converts to a variable option. Preferreds thus experience less “extension of duration” when rates rise and, in fact, the securities can capture increases in interest rates.
As Senior Portfolio Manager JR Humphreys explains, the Sheaff Brock Preferred Income portfolio is made up of 20–25 preferred stock issues with three-to-five-year call protection. A number of tactics are used for risk management, including:
- Managing Interest rate risk–fixed-to-float securities are used (these pay fixed dividends for five years from issue, then float with interest rates)
- Using sell triggers when yield-to-call falls to an unattractive level
- Emphasizing income and capital preservation
- Including issues in sectors other than banking, including utilities
When thinking about interest rate changes, Humphreys cautions readers, don’t get hung up on what the Fed does with interest rates in the U.S. The Fed’s changes only control the short end of the yield curve, he explains. The five-, ten-, twenty-, and thirty-year results are influenced by world economic growth and inflation, Humphreys adds.
In a rising rate environment, preferreds could turn out to be particularly apropos!