Why Preferred Stock, Muni ETFs Worth A Look
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.”
Muni Market Tells Similar Tale
The story isn’t all that different in the muni market.
The second-best-performing fixed-income ETF in 2015 (behind PGF) was the Market Vectors CEF Municipal Income (XMPT) with total returns of 8.48%. XMPT is anything but plain vanilla. The fund provides exposure to an index of U.S.-listed muni-bond closed-end funds, which are known to trade at premiums or discounts to fair value because they lack the arbitrage mechanism that ETFs have.
That matters to the extent that XMPT tilts toward those CEFs that trade at a discount, with the idea that they are more likely to increase in value and deliver a higher yield. The fund also applies some leverage. But whatever the complexities of the fund, the core point is that XMPT focuses solely on muni closed-end funds.
The giant in the muni ETF space, the iShares National AMT-Free Muni Bond (MUB | B-79), with $6 billion in assets, delivered nearly 3% in 12 months. Relative to broader AGG, that’s still a strong performance.
Charts courtesy of Stockcharts.com
Lots To Like In Muni Market
“High-quality investment-grade munis have seen demand outstrip new supply for several years now,” Rieger said. “The lack of new supply is an important aspect of the muni market. Many muni investors are reinvestors—they don’t just take the coupon and cash, they actually reinvest in the muni market. As a result, there’s a natural demand for munis.”
Another factor helping munis is a rising tax rate environment, and the uncertain outcome from the presidential elections coming up. To investors, taxation is a real issue, and munis generate nontaxable income with relatively low headline risk.
Outlook For 2016
Going forward, the outlook isn’t all that different from recent performance.
The Federal Reserve’s decision to begin increasing rates late last year—and expectations that rates will gradually move higher this year—should help flatten the yield curve as short-term rates move higher in reaction to the Fed, and long-term rates continue to respond to economic drivers such as inflation expectations and growth, Tucker says.
Markets should also be faced with investors’ reassessing their expectations as China’s troubles linger, and as concerns about global growth and commodities markets—particularly oil—persist. All of that points to more volatility in 2016, according to him.
“When the smoke clears, I expect it to be a modest year in terms of growth and in terms of movements in price,” Tucker said. “In that kind of market, you’re likely to see negative price return from your fixed-income investments, but you will see a lot more return driven by income. It should be similar to last year—investments that provide higher income will deliver stronger performance.”
Tucker added: “But a word of caution: preferreds have a lot of equitylike properties when it comes to volatility.
Contact Cinthia Murphy at cmurphy@etf.com.
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