2023-12-29 08:30:00 ET
Summary
- We look at a key sector for income investors to be actively engaged for massive rewards.
- 2022-2023 has beaten down this sector heavily, but 2024 could provide the opposite outcome.
- I buy for income, and I get capital gains as a bonus.
Co-authored by Treading Softly.
Having three children of my own, I have gotten very accustomed to what art by a child will look like. Yet, it's rare that I can look at something as important as U.S. interest rates and see a child-like art pattern within it. Take a look below at the 10-year chart of the U.S. Bank prime loan rates, which closely follow the U.S. prime rate as it's moved by the Federal Reserve. It looks simply like an ocean wave drawn by a child.
Interest rates have climbed rather swiftly. All sorts of credit instruments have been rapidly repriced to adjust to the new rate environment. When interest rates were extremely low, the low-rate at PAR investments such as bonds and preferred securities with fixed rates, were able to trade at par or even exceeding par to premiums because the market was driving for certain yields. The only way to change the yield on a fixed interest rate bond or preferred is to change its trading value. While the preferred securities will still mature at PAR when it is called, or if it's bond at its maturity date, the intermediate trading price will be adjusted to give it the yield the market is looking for. What this has caused is for the overall bond market and preferred market to essentially get an uppercut and a direct punch in the face one after another. We can see in the last three years that when interest rates started to climb rapidly, the overall bond market and preferred market rapidly fell.
The expectation for U.S. interest rates is to plateau and then decline as we enter into a recessionary period. What this means is that as rates decline, bond and preferred values will return to what they were trading at previously. While we don't expect that interest rates will reach the zero interest rate environment that we saw during 2020, we do expect that interest rates will fall into more of a neutral realm, providing a great uplift to investors who are buying preferreds and bonds now.
Today, I'm going to take a look at one outstanding ETF that has outperformed the index as a whole but also has room to vastly outperform the index as preferred values climb rapidly.
Let's dive in!
One Outstanding Choice
Virtus InfraCap U.S. Preferred Stock ETF ( PFFA ), yielding 9.6%, is a fund that invests in preferred equity with a style that is most similar to the HDO Model Portfolio.
PFFA differentiates itself from other ETFs through two main features: It utilizes modest leverage (typically 20-30%), and it is actively managed. Many ETFs simply follow an index, and the manager doesn't actively pick investments or weightings. PFFA is managed more like a closed-end fund, actively picking investments.
As a result, PFFA has a portfolio that is focused on some of the best and highest-yielding opportunities among preferred shares. As a result, instead of the typical mix of banking and insurance preferred, we see PFFA with a portfolio where real estate, mortgage REITs, and industrials lead the way. Source .
PFFA Fact Card
Among PFFA's top holdings, we see several names that are familiar to HDO: Source .
PFFA Website
PFFA's active management has added significant value for investors. We know that leverage cuts both ways. Being leveraged is a benefit when prices are rising because it increases returns, but when prices are falling, leverage amplifies the downside as well.
PFFA started in 2018 and has gone through two bear markets for the preferred sector. First, the COVID shock which sent prices plummeting, and then in 2022, the deepest sustained sell-off of preferred equity since the Great Financial Crisis. If someone told you in 2018 that there would be two significant downswings in preferred shares within the next five years, you probably would have chosen to avoid a leveraged preferred fund.
Sometimes it's a good thing you can't see the future, it might lead you to make the wrong decisions. PFFA has more than doubled the return of an unleveraged ETF like iShares Preferred and Income Securities ETF ( PFF ).
That PFFA was able to achieve this outperformance during a period that has been very difficult for preferred equity is outstanding. Imagine how much PFFA will be able to outperform in a market that is good for preferred!
Conclusion
With PFFA, we can see that even through two bear markets within the preferred sector, they've been able to double the performance of their index. This is largely due to their active management and the slight use of leverage. One benefit of it being an ETF is that there is no discount or premium to figure out. It trades at the value of its overall holdings, and while many of those holdings trade at a discount to their PAR value, what you're buying is what you're getting. There's no question about whether it's at a discount or premium at that moment.
When we look over the entire preferred sector, we see that there is a vast abundance of opportunity available to careful and diligent income investors. Many offerings are trading at wide discounts, largely because at PAR their yields are extremely low. At this time, I would encourage investors who are looking for income and are more risk-averse, to strongly consider buying fixed-rate preferred securities, largely because those will start providing great capital gains on top of their income returns as interest rates start being cut. If you're not comfortable investigating and researching individual preferreds, PFFA is a great alternative.
When it comes to retirement, the last thing you want to do is worry about babysitting your portfolio. That's why we recommend having at least 42 different individual securities in your portfolio, as well as a 40% exposure to fixed income. These would be baby bonds, bonds, and preferred securities. That section of your portfolio this year wouldn't be a glowing light of success, but it would be a bastion of stability in its income, providing you with steady and strong income, regardless of what its price is doing day to day. The fixed-income sector can provide you with a strong and steady income and reward you with capital gains if you invest diligently at the proper times. Your retirement should be a time when you get to enjoy doing what you want without having to worry about what others are thinking. Having a portfolio that pays your way can help you achieve that.
That's the beauty of my Income Method. That's the beauty of income investing.
For further details see:
I Am Buying Preferred Stocks Hands Over Fist: PFFA