Blue Haven

Swap out those dividend stocks for preferred stocks instead 

By March 1, 2020 No Comments

When the stock market sells off the way it has it’s easy to look at investments through the vacuum of the S&P 500. The two most common question we get after a week like this is (1) should I buy stocks right now (2) should I move money into safer assets like bonds? These questions assume that stocks are the only game in town and bonds are the only way to invest conservatively. In reality, the stock market sell-off has created a number of opportunities across different asset classes. And bonds, while historically much safer than stocks, look relatively expensive.

Long Bonds are expensive

TLT, a long maturity bond ETF, is up nearly 15% through the first two months of the year! Can you imagine how many people would be warning of a bubble if stocks were up that much so quickly? Everyone would be expecting stocks to drop. Furthermore, over the last one year, TLT is up 30% vs a 5.40% gain for the S&P 500. In addition, AGG, a more conservative aggregate bond index, is now up 3.43% YTD and 9% over the last year:

Year-to-date chart of TLT, S&P 500 (SPX), and AGG:

One-year chart of TLT, S&P 500 (SPX), and AGG:

To help put this in perspective, TLT has posted an annualized 10-year return of 8.26%. The current year-to-date gain of 14.64% is 1.75x greater than that, and we still have a month left in the first quarter.

Who wants to buy stocks high?

If you don’t want to buy stocks when they’re at a high why do you want to buy bonds when they’re at a high? For income? The 30-year Treasury yield is currently 1.68%. For comparison, the S&P 500 currently yields 1.97%, per The gains in long bonds, and even an aggregate bond like AGG, is coming from price performance, not yield. And while it is true, that the fed will likely lower interest rates, one has to wonder how much of that policy move is already priced into the bond market? On the other side, how much economic pain did stocks price in last week? In both cases, we think the answer is a lot, and possibly more than is appropriate.

Appealing income opportunities

As yields move lower and lower, finding income-producing investments gets harder and harder. However, one asset class may be offering a particularly attractive entry point right now: preferred stocks. These types of stocks pay a fixed dividend and are generally less volatile than regular common stocks. We invest in these through preferred stock ETFs. Such as PFXF, PFF, VRP, and PFFD to name a few. As you can see, these ETFs fell hard over the last two weeks, but were still down less than half the loss of the S&P 500 (with VRP the lone exception):

The price drops mean the yield offered by each ETF has risen. PFXF is now yielding 5.96%, PFFD 5.39%, and VRP 5%. The graph below shows the 5-year correlation of VRP and PFXF vs the S&P 500 (VOO), long bonds (TLT), and aggregate bonds (AGG). (Note: PFFD is not included because it does not yet have a 5-year history):

preferred stock ETF correlation to S&P 500

Notice that our preferred stock ETFs have a relatively low correlation to TLT and AGG. This is beneficial because it means if bonds are indeed overvalued, and decline in price, they aren’t likely to bring preferred stock ETFs crashing with them. In fact, these preferred stock ETFs act more like the broader equity market than they do the broader bond market. With that said, the correlations to the S&P 500 hovers right around 0.50. So while there is a correlation there, it is safer than owning the broad equity market.

Preferred stock ETFs beat dividend ETFs

When looking for conservative equity exposure that can generate income, most people wind up owning blue-chip dividend stocks. This, in our opinion, is a grave mistake. Most dividend ETFs today perform very similarly to the S&P 500. In fact, during the latest market drop, popular dividend ETFs like VYM, DDIV, HDV performed noticeably worse than the S&P 500:

And they also have very high 5-year correlations to the S&P 500:

In our opinion, if you want income, swap out those dividend ETFs with preferred stock ETFs instead. You’ll get greater yield and lower volatility that way. Because dividend ETFs act similar to the S&P 500 you’re basically just buying beta when you own them. And you’d get a more efficient beta by just owning an S&P 500 index fund like VOO. Want income + growth? Pair an ETF like PFXF with VOO. But be careful thinking dividend ETFs are the best idea for income in a down market.

One area of debate is whether to include preferred stock ETF allocation on the equity side of a portfolio or the bond side. For more aggressive investors, we think preferred stock makes sense under a bond allocation. For more conservative investors, we recommend including preferred stock ETFs in equity allocations.

The bottom line

Stocks have fallen and risk, as measured by volatility, has risen across asset classes. Bonds, while historically much safer than stocks, are trading at a premium to their own historical returns. As a result, we’ve been reducing our bond exposure across a number of portfolios. For some clients, this means selling bonds to buy stocks. For others, this means moving from typically safer bond funds, like AGG, into riskier fixed-income vehicles like PFXF or PFFD.

We caution against applying binary logic to markets. For example, stocks going down 12% doesn’t mean everything is going down 12%. Or just because bonds are historically safe investments doesn’t mean they are safe investments right now. Specialized dividend ETFs don’t actually protect you from the market’s losses. In fact, recently, they’ve exasperated them. If you are looking for current income, consider preferred stock ETFs. And if you want to get equity exposure in an intelligent manner, consider the opportunities in buffered ETFs like BJAN.

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