Preferential Times for Preferred Income Strategies?
Not all that glitters is gold
June 2023. Reading Time: 10 Minutes. Author: Nicolas Rabener.
SUMMARY
- Preferred income funds offer exceptionally high yields
- However, the higher the yield, the lower the total return
- The diversification benefits of these funds were limited
INTRODUCTION
Although the job of a stock analyst is not easy, fixed-income analysts have it arguably harder. Sure, there might be multiple share classes for a few stocks like Alphabet or Berkshire Hathaway, but equity is perpetual while fixed-income instruments mature and need to be refinanced on a regular basis. While equity analysts can focus exclusively on what is driving the equity value, fixed-income analysts often have to analyze various loans and bonds that each require reading lengthy prospectuses in order to understand the entire capital structure.
However, there are some instruments that sit between both asset classes namely high yield, mezzanine, and convertible debt, as well as preference shares. The first three of this list are covered by fixed-income analysts, while the latter is sometimes looked after by equity analysts.
Preference shares entitle investors to fixed or variable distributions that get paid before any dividends from the operating business are issued, but rank subordinate to debt. Given this, these instruments tend to offer exceptionally high yields. However, not all that glitters is gold and high yields are often associated with high risks. In this research note, we will explore preferred income funds.
UNIVERSE
We focus on all preferred income funds trading in the US with a minimum track record of five years. This universe includes a total of 36 mutual funds and ETFs that manage approximately $60 billion of assets.
The yields of preferred income funds are significantly higher than US investment-grade and high-yield bonds, which explains their popularity with yield-seeking investors. The average management fee of 1.23% indicates that these funds are primarily sold to non-price-sensitive retail investors (read Resist the Siren Call of High Dividend Yields).
