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Why Income Investors Should Consider Convertible Bonds, Preferreds ETFs

·5 min read

This article was originally published on ETFTrends.com.

Income-minded investors should consider the benefits of preferred securities and convertible bonds exchange traded fund strategies to bolster their after-tax income.

In the recent webcast, Diversify Your Income Sources: The Best Kept Secret in Portfolio Construction, Sandra Testani, vice president of ETF product and strategy at American Century Investments, explained the benefits of preferred stocks, which are hybrid investments that share characteristics of stocks and bonds and offer the potential for high current income, higher credit quality, diversification benefits, and lower interest rate risk.

Testani argued that preferreds in a portfolio could provide enhanced yields without significantly sacrificing credit quality, offer diversification away from traditional fixed-income investments with less vulnerability to rising rates, and, for tax-sensitive investors, give attractive after-tax yield as income on preferreds may be classified as qualified dividend income.

"At a time of scarce yields and growing tax challenges, preferred securities provide the ability to enhance after-tax income and return potential, while providing diversification away from other fixed-income investments," Testani said.

"Favorable tax treatment of qualified dividends can provide superior after-tax yield and benefit tax-sensitive investors," she added.

Testani also underscored the diversification benefits of preferreds as the correlation to stocks and traditional fixed-income securities may help enhance yield and reduce volatility in a broad portfolio.​ Preferred securities are generally high quality, issued by well-capitalized companies in highly regulated industries such as banking, insurance, utilities, and telecommunications — offering attractive yields comparable to lower-rated bonds.

Furthermore, Hitesh Patel, vice president and portfolio manager at American Century Investments, argued that with exposure to industries that stand to benefit from rising rates, a diversified portfolio of preferred securities can help reduce interest rate risk. ​A diversified portfolio of preferred securities has historically shown to be resilient in past rising rate environments.​

As a way to tap into this market, Patel pointed to the actively managed American Century Quality Preferreds ETF (QPFF).

The American Century Quality Preferreds ETF has a quality focus that overweights issuers believed to offer more sustainable dividends throughout the market cycle, employs sector-specific assessments to address large benchmark banking exposure, and monitors credit, liquidity, rate, and structural risks to mitigate sharp price declines.

QPFF tries to identify high-quality issuers by eliminating issuers with the highest likelihood of suspending dividends in challenging market environments and focusing on earnings quality and market capitalization. The fund managers also employ sector-specific screens to further refine the investment universe to account for idiosyncrasies among banking and non-banking sectors and optimize remaining issuers based on valuation and yield. The strategy seeks the securities with the best structural features, accounting for market inefficiencies that may impact relative valuation among issues. Lastly, the ETF ensures alignment with aggregate portfolio risk/return objectives, liquidity, and portfolio constraints.

The desired outcome is a preferred portfolio with higher quality and higher profitability issuers that can sustain dividends throughout the market cycle, lower exposure to cyclical sectors, larger market capitalization, and attractive portfolio yield without significantly sacrificing credit quality.

"Our process addresses some of the deficiencies of the broad index-based passive approach which ignores issuer fundamental risks and structural complexities specific to this asset class and are unable to shift the mix of securities and risk exposure according to changing market conditions​," Patel said.

"Our quantitative and fundamental process identifies quality issuers with low credit risk, low leverage and strong stable earnings with high profitability with the ability maintain stable dividends over multiple business cycles."

Testani also underscored the benefits of convertibles, fixed income securities with an embedded option to convert to equity. These assets offer the potential for attractive risk-adjusted returns, upside potential with limited downside capture, low sensitivity to interest rates, and yield advantage relative to growth equities.

Testani argued that convertibles in a portfolio provide exposure to growth equities with higher yield and lower downside risk, and they provide diversification away from traditional fixed-income investments, with less vulnerability to rising rates. Convertibles tend to be issued by cyclical, growth-oriented companies. Many of the issues are not rated and, due to call features, may have very short durations.

For convertible bond exposure, the American Century Quality Convertible Securities ETF (QCON) is an actively managed convertible bond portfolio that focuses on quality, industry diversification, and balancing beta exposure to optimize risk/return potential for investors seeking a diversifying alternative strategy.

"Investors have traditionally owned convertibles via low-cost passive portfolios designed to mimic a broad benchmark or expensive actively managed mutual funds. We believe that the broad index-based passive products which allocate across the U.S. converts universe based on the market weight of the underlying issue in the market are agnostic to the risks and structural complexities specific to this asset class which can lead to unintended outcomes. The passive structure contains inherent flaws. They ignore issuer fundamental risks and are unable to shift the mix of securities and risk exposure to changing market conditions," Patel said.

The American Century Quality Convertible Securities ETF overweights issuers with a stronger earnings profile, stronger balance sheets, and higher-than-average credit ratings. It also targets a more balanced beta range for the portfolio to mitigate sharp price declines, and aims to diversify across industries and sectors to address benchmark concentration.

QCON’s bond-like convertibles segment eliminates issuers with the highest default risk and optimizes issuers based on valuation and yield. The ETF’s equity-like convertibles portion eliminates issuers with the lowest profitability and lowest realized growth, instead optimizing issuers based on profitability and growth. The portfolio then seeks the securities with the best structural features, accounting for market inefficiencies that may impact relative valuation among issues. Lastly, it ensures alignment with aggregate portfolio risk/return objectives, liquidity, and portfolio constraints.

The desired outcome is a convertible bond portfolio with higher quality issuers, lower exposure to cyclical sectors, and lower exposure to highest and lowest beta securities.

Financial advisors who are interested in learning more about income strategies can watch the webcast here on demand.

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