Preferred equity is an often-overlooked asset class that’s gaining renewed attention. Recently, Wealth Advisor Managing Editor Scott Martin sat down with Jim Hodapp, a Senior Vice President and Portfolio Specialist at Principal Asset Management with more than four decades of experience in the preferred market, to explore why preferred equity presents a compelling opportunity for investors, especially in the current interest rate environment.
At the forefront of this discussion are two actively managed exchange-traded funds (ETFs) from Principal Asset Management: the Principal Spectrum Tax-Advantaged Dividend Active ETF (ticker: PQDI) and the Principal Spectrum Preferred Securities Active ETF (ticker: PREF). These ETFs, designed to capitalize on the nuances of the preferred equity market, offer investors distinct approaches to accessing this asset class.
Understanding Preferred Equity
Preferred equity occupies a unique position in the capital structure, sitting between senior debt and common stock. As Hodapp explains, “We’re part of the fixed income allocation, not really part of an equity allocation. We’re down the capital structure—we’re junior to senior debt and subordinate debt, but we’re senior to common stock.”
This positioning offers a blend of characteristics that can be attractive to investors seeking income with potential for capital appreciation. Unlike common stock dividends that fluctuate with company profits, preferred equity typically offers more stable income through fixed- or floating-rate coupons.
The Appeal of Actively Managed Preferred ETFs
Hodapp highlights two Principal actively managed ETFs in the preferred space: PREF and PQDI. PQDI focuses on securities that generate qualified dividend income, potentially providing tax advantages for investors, while PREF exclusively targets $1,000 par securities with float or reset coupon features.
Hodapp explains how their unique and active management strategies aim to navigate the complexities of the preferred market and potentially deliver superior outcomes for investors. These ETFs offer distinct advantages over passive strategies in navigating the complex preferred equity market.
PREF: Focus on $1,000 Par Securities
PREF, launched in 2017, focuses exclusively on $1,000 par securities. Hodapp notes, “Every security either has a float or a reset coupon feature. So really, most of what we do is either resettle coupons, fix to variable coupons, or fix to floating-rate coupons.”
This structure provides several advantages:
- Potential for rising income in a declining rate environment
- Less volatility compared to fixed-rate preferreds
- “Pull to par” effect as securities approach reset dates
PQDI: Broader Exposure with Tax Advantages
PQDI offers a broader approach, including $25 par securities and contingent convertibles (CoCos). “PQDI is more focused on that qualified dividend,” Hodapp explains. “Every securities dividend pays a dividend that’s qualified dividend income.”
This focus on qualified dividend income can offer tax advantages for investors in taxable accounts, as these dividends are typically taxed at lower rates than ordinary income.
The Reset Advantage in a Changing Rate Environment
One of the most compelling aspects of preferred equity in the current market is the potential for rising income even as interest rates decline. Hodapp points to the Federal Reserve’s anticipated rate cuts as key to bringing inflation down to 2%:
If you look at the Fed’s dot chart, they plan on taking short rates, which are currently 5.25%, 5.5%, all the way down to 2.5% over the next three years. As that happens, clients that are out there rolling Treasury CDs, money market funds at around 5%—they don’t own that rate. They’re just renting that rate. As the Fed lowers rates from 5.25% and 5.5% to 4% to 3% to 2.5%, those investors are going to see their income cut in half.
In contrast, the reset features of many preferred securities in ETFs such as the actively managed PREF fund can lead to higher coupons even as rates fall. “That float or reset feature on average is three years in the future “with the benchmark mainly being five-year Treasuries plus about 355 basis points,” Hodapp says.
So, today, you’re buying a 5.20% average coupon at $97 and change. But if the short rates move down to 2.5%, we think five years are going to be somewhere between 3.5% and 4%, where they are right now. So, the interesting thing is as your rate’s getting cut in half on those short-term instruments, as the Fed lowers rates, our coupons likely will actually go up a couple hundred basis points. … So, you’d actually be getting rising income in a declining rate environment as the Fed is cutting rates. That’s a very unusual and very good feature for investors.”
This unique characteristic sets preferred equity apart from many other fixed income investments and can provide a valuable hedge against declining rates.
The Importance of Active Management in Preferred Equity
The preferred equity market is complex, with numerous structures and variations even within a single issuer. Hodapp emphasizes the critical role of active management: “First you have to make sure you get the issuer right, and then it’s our job to find the best structure to meet the client’s needs based on taxes, total return, current income. So active management does make an enormous difference in the space.”
He cites an example of outperformance during the COVID-19 pandemic market stress of March 2020, when active investment strategies declined 20% compared to their passive counterparts’ loss of 34%. “That’s almost unheard of in a single asset class to see outperformance by 1,400 basis points.”
Active management is crucial in preferred equity owing to several key factors. The market features diverse security structures, including fixed, floating, and reset coupons, which require careful navigation. Additionally, preferred securities come with varying par values, typically $25 or $1,000, each with its own market dynamics. Tax treatments differ as well, with some securities generating interest and others paying dividends, impacting after-tax returns. Finally, each issuer presents unique risks and opportunities, demanding thorough analysis to optimize portfolio performance and manage risk effectively.
Hodapp notes that his firm focuses on high-quality issuers, stating, “We only buy preferreds from issuers whose senior debt rating is investment grade rated. We are typically less volatile in times of stress or times of illiquidity due to our high credit quality bias.”
The “Pull to Par” Effect
A unique feature of many preferred securities is what Hodapp terms the “pull to par” effect. This outcome occurs as securities approach their call or reset dates. “As these securities are trading at 80 cents on the dollar,” he says, “it could look like there’s a magnet out there pulling these things back to par because they’re either going to get called away at par or they’re going to reset.”
This effect can provide a level of price stability and potential capital appreciation, particularly for securities trading below par.
Current Market Opportunity
Hodapp sees the current market environment as particularly attractive for preferred equity. “We think now is a great time to be adding to positions in preferreds in anticipation of getting actually higher income even as interest rates come down,” he explains.
In addition, he views concentration in the preferred equity market positively. Three key sectors account for some 90% market share: banks at about 60% of the market, insurance companies at roughly 20%, and utilities at approximately 10%.
“What do banks, insurance companies, utilities have in common?” he asks. “They’re regulated entities. We love regulation.” Regulatory oversight can provide an additional layer of stability and predictability for these issuers.
Portfolio Considerations for Advisors
When considering how to incorporate preferred equity into client portfolios, Hodapp offers several insights:
- Fixed Income Allocation: “We typically see money pull from high yield to preferreds.”
- Complementing Municipal Bonds: “We typically see wealthy investors with muni portfolios have a preferred allocation because munis are tax free. These are tax advantaged, and in many cases, that brings down your volatility and brings you a better after-tax return on a blended portfolio.”
- Yield Enhancement: “We’ll see clients that would normally own senior debt come down the capital structure, take the subordination risk, get paid extra income.”
- Unique Structure: “That structure doesn’t exist in the muni market. That structure doesn’t exist in the corporate market. That structure doesn’t exist in the high-yield market. So, you’re getting extra income, but you’re also bringing in that structure with that pull to par, bringing you more price stability.”
Forward-Looking Solutions
Preferred equity offers a unique set of characteristics that can be particularly attractive in the current market environment. The potential for rising income in a declining-rate environment, coupled with the stability provided by high-quality issuers and the pull-to-par effect, make this asset class worthy of consideration for many portfolios.
However, the complexity of the preferred equity market underscores the importance of active management. By leveraging the expertise of seasoned managers and the flexibility of ETF structures such as PREF and PQDI, advisors can potentially enhance their clients’ income strategies while managing risk in a changing interest rate landscape.
As with any investment decision, careful consideration of individual client needs, risk tolerance, and overall portfolio composition is essential. Nevertheless, for advisors seeking to optimize income strategies and diversify fixed income allocations, preferred equity presents a compelling opportunity worth exploring.
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Additional Resources
- Contact Principal Asset Management
- Principal Spectrum Tax-Advantaged Dividend Active ETF (PQDI) Fact Sheet
- Principal Spectrum Preferred Securities Active ETF (PREF) Fact Sheet
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Disclosures
Carefully consider a fund’s objectives, risks, charges, and expenses. For a prospectus, or summary prospectus if available, containing this and other information, visit www.PrincipalAM.com or call sales support at 800-787-1621. Please read it carefully before investing.
ALPS Distributors, Inc. is the distributor of the Principal ETFs. ALPS Distributors, Inc. and the Principal Funds are not affiliated.
Unlike typical ETFs, there are no indices that the Principal ETFs attempt to track or replicate. Thus, the ability of the Fund to achieve its objectives will depend on the effectiveness of the portfolio manager.
Investing involves risk, including possible loss of principal.
Past performance is no guarantee of future returns.
Fixed-income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Risks of preferred securities differ from risks inherent in other investments. In particular, in a bankruptcy preferred securities are senior to common stock but subordinate to other corporate debt. Contingent capital securities (CoCos) may have substantially greater risk than other securities in times of financial stress. An issuer or regulators decision to write down, write off or convert a CoCo may result in complete loss on an investment.
Asset allocation and diversification do not ensure a profit or protect against a loss. Investing in ETFs involves risk, including possible loss of principal. ETFs are subject to risk similar to those of stocks, including those regarding short-selling and margin account maintenance. Investor shares are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Ordinary brokerage commissions apply.
There can be no assurance as to the portion of the Fund’s distributions that will qualify for favorable federal income tax treatment. The Fund may make investments and pay dividends that are ineligible for favorable tax treatment or that otherwise do not meet the requirements for such treatment, and shareholders must satisfy certain requirements to take advantage of beneficial tax treatment.
ETFs can be tax efficient in that they are exchange-traded and redeem creation units from authorized participants by using redemptions in kind, which are not taxable transactions for the Fund. However, capital gains are still possible in an ETF, and if you reinvest the earnings of the ETF, you may owe taxes on your funds even if you didn’t sell any shares, potentially eating into your returns.
Spectrum Asset Management, Inc. is an affiliate of Principal Global Investors. Spectrum is a leading manager of institutional and retail preferred securities portfolios and manages portfolios for an international universe of corporate, insurance, and endowment clients.
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