Preferring Preferreds for Income
Michael is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
“I prefer the folly of enthusiasm to the indifference of wisdom.” - Anatole France
With low yields and the Fed's stated intention to keep interest rates depressed until at least 2014, its become a harder and harder environment for income-oriented investors to collect cash flow from their positions. As I have noted in prior writings on several financial websites, there appears to be the growing possibility that 2012 ends up being strongly reflationary, whereby bonds underperform stocks and bond yields rise independent of the Fed. If you position into Treasuries now as that's happening, you've locked in lower rates and unfortunately then are dealt with a loss on the actual bond position (in unrealized terms).
An alternative could be to consider Preferred stocks, which are a “hybrid” of bonds and common equity. Take a look below at the price ratio of the iShares S&P US Preferred ETF (NYSEMKT: PFF) relative to the iShares Treasury 7-10 Year Bond ETF (NYSEMKT: IEF). As a reminder, a rising price ratio means the numerator/PFF is outperforming (up more/down less) the denominator/IEF.
Notice that during the Summer Crash of 2011, Preferreds severely underperformed as the European crisis erupted. This should make some sense because Treasuries rallied in a “flight-to-safety” trade while PFF, which is 70% exposed to Financials, took it on the chin.
However, since then, the two have performed roughly in line, with what appears to be a potential breakout trend occurring in the far right of the chart. With a yield of over 7% and what appears to be an abatement of the financial crisis and recovery in bank stocks, the odds might favor that Preferreds recover to pre-Summer Crash levels in relative terms. The exposure to the Financials sector is high, meaning that a bet on Preferreds is likely also an automatic bet on the Financials sector.
The author, Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing. The commentary does not constitute individualized advice. The opinions herein are not personalized recommendations to buy, sell or hold securities.