The bull market seemed to have returned after a December that spooked investors. The S&P 500 pretty much reclaimed its pre December level after an 8.1% return to the index for the month of January. Despite this rally, many institutional investors are parking funds in cash with the expectation that the long bull market is due for a longer term correction.
There is a lot to point to in order to make one think that putting your funds in cash for the time being is worth it. Besides having been in a long equity bull market, interest rates are rising which is reducing bond prices and creating the potential for negative returns in that space. Only short term treasuries seem to carry the smallest risk in a rising rate environment but with current 3 month T-bill at 2.4%, the returns are still small based on the historical average.
Cash and T-bills aren’t a long term solution for those looking for more meaningful returns. It’s a short term move to avoid larger losses. If you are holding a lot of cash right now, there is an argument I would make that holding some of that in higher yielding securities may offer some benefits.
The Advantages of High Yield
The high yield bond market, or the junk bond market, as it used to be known, consists of bonds that are rated below Baa3 and BBB- by the major ratings agencies. These are considered the riskier companies to lend to and compensate for the higher risk by paying a higher yield.
Since defaults in this space tend to be higher, prices tend to move more with the perception of imminent defaults as opposed to rising interest rates and that may be one of the main advantages of these bonds in this environment. Despite the 30 year downtrend in interest rates overall, the yield in the high yield market has remained pretty consistent as can be seen below.
Source: St. Louis Fed
There are some notable peaks in the historical yield charred above. Those are times of higher default rates. The sharpest jump was during the financial crisis, which produced double digit losses at that time. As defaults stabilized and prices roared back, so did the returns.
I happened upon a chat room one day discussing this sector and I liked the way one long time investor in the sector described its swings: if you can ride out the defaults, it’s a pretty good return.
In fact, that commentator had a point, high yield has historically offer an asset class that still has a lower volatility than common stocks but still with a decent return as can be seen below.
Source: TIAA
What stands out in the above is the standard deviation. A mix of large and small cap stocks would almost double the volatility while only providing about a quarter more return. This is reflected in the Sharpe ratio to the right which measures return versus volatility.
Across the credit spectrum this assets class has historically performed better than the investment grade space even when taking into account default rates as TIAA points out.
Source: TIAA
The one disadvantage high yield bonds offer in my view is their tax treatment. The income is classified as ordinary interest income for tax purposes and therefore is taxed similar to your wage. No special treatment here. For this reason there is another asset class you may want to consider for a yield pick up.
Preferred Shares
Preferred shares or preferred equity as they are also called, are kind of a hybrid debt and equity security. The payment for preferred shares comes from net income prior to payouts to common shareholders. These shares are a step above common shareholders in terms of priority of payment but below debt holders.
Preferred shares are usually issued at a fixed price and pay a dividend that tends to offer a higher yield than the company debt. This is because the dividend is coming from net income which tends to be more volatile than operating cash flows that pay debt.
When we stack the yield up against other fixed income investments such as high yield and investment grade bonds, the return tends to compare pretty well (in green below).
Source: iShares
Notice that the return tends to be a bit lower than that of the high yield bonds and this is likely due to the tax treatment for preferred dividends. Dividends for preferred shares are considered qualified dividends because the funds have already been taxed at the corporate level. This means that most holders of this debt will pay 15% or 20% tax on the income as opposed to higher taxes these same holder may have to pay on interest from high yield debt.
One Unique Risk to Preferreds
So we know that preferreds are risky, potentially volatile but also offer better tax treatment. However there is a particular industry concentration that you may want to assess when adding this type of asset to your portfolio. The overwhelming majority of the companies that issue preferred shares are banks and financial companies. If you already have exposure to this industry or very heavy exposure (like you work in the industry, and this your income is dependent on industry trends) you may want to be cautious about you exposure to preferred ETFs that you can find out there. Take a look at the sector breakdown provided by iShares.
Source: iShares
Of course you can always avoid trying to buy the index by simply buying a company’s preferred shares directly but the sector concentration is important to take note of for investors.
Conclusion
If you can handle the volatility and the industry exposure of these asset classes, you may we’ll be rewarded with some growth. An easy way to dip your toe in either of these is through the ETFs that cover these respective assets. Some of the most popular include:
Preferreds:
- PowerShares Financial Preferred Portfolio ETF (NYSEARCA:PGF)
High Yield:
- iShares iBoxx $ High-Yield Corporate Bond ETF (NYSEARCA:HYG)
- SPDR Bloomberg Barclays High-Yield Bond ETF (NYSEARCA:JNK)
As always, do your research and know your comfort level when it comes to risk. If after doing your due diligence, you think these assets deserve a portion of your portfolio, you could be handsomely rewarded.
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