In 2015, preferred stock and muni bond ETFs were some of the best-performing fixed-income investments of the year, delivering the biggest total returns in the asset class. And 2016 is, so far, promising to be good to both segments again.
Part of what made those pockets of fixed income shine last year was the relatively weak performance of equity and fixed-income markets in general. As Matt Tucker, head of fixed income for iShares, put it, “In 2015, you didn’t see strong performance from either stocks or bonds. The asset classes that did well were those that were not driven by price performance, but those that had a strong income component.”
Income Component Driver
The best-performing fixed-income fund in 2015 was the PowerShares Financial Preferred (PGF | B), which delivered total returns of 7.8%. Those gains came as U.S. large-cap equities and broad fixed-income strategies ended the year practically flat. For instance, funds such as the iShares Core S&P 500 (IVV | A-98) and the iShares Core U.S. Aggregate Bond (AGG | A-98) delivered 1.28% and 0.48%, respectively, in total returns, for comparison.
PGF’s strong performance—and that of other preferred ETFs such as the iShares U.S. Preferred Stock (PFF | B), the biggest in the segment, with $14.3 billion in assets—was tied to strong income.
PGF and PFF have trailing 12-month yields upward of 5.7%. Relative to the broad equity market, PFF was down in price terms last year, but because of the higher income component relative to traditional common stock, it outperformed significantly in total returns.
“It was really a story about income driving performance in a year when price return was muted,” Tucker said.
Preferred stocks are often referred to as equities that behave like a bond. They are officially equity, but they typically deliver income in the form of fixed dividends, and they carry less risk than other equity securities due to their ranking in the corporate ladder.
The majority of the segment is also floating rate—a feature that’s becoming increasingly beneficial as interest rates rise, J.R. Rieger, of S&P Dow Jones Indices, says.
Volatility A Key Factor
Another factor helping preferreds is volatility relative to the broad stock market.
“We had a lot of volatility in the equity markets in 2015, but not as much in the preferred markets,” Rieger noted.
“The income aspect of preferreds is in demand relative to other fixed-income classes. It’s incrementally higher given the level of risk relative to that of higher-income investments like high yield,” he added. “To get an equivalent yield out of a corporate bond, you would be extending well into the high-yield segment.”