Beware Lazy Diversification In Preferreds – Seeking Alpha

The latest market drawdown has hit the preferreds market like a ton of bricks. Lower short-term rates have hammered fixed-to-float securities, while cyclical sectors like banks and REITs, which are heavily represented in the population, took a heavy brunt of an oncoming recession. Investors who thought they held relatively diversified portfolios may have been surprised by sharp and broad-based losses. In this article, we take a look at a number of portfolio dimensions that investors may be overlooking when constructing their preferreds portfolios.

Our takeaway is that investors should look beyond merely increasing the number of securities in the portfolio, allocating to higher-quality stocks or picking across a number of different sectors. Other dimensions worthy of consideration are intra-sector, coupon type and duration diversification, as well as institutional vs. retail market exposure.

What do investors typically do in order to diversify their portfolios? The traditional approaches are selecting a sufficiently high number of securities, allocating across different sectors, and selecting higher-quality securities for at least a part of the portfolio.

We call these insufficient diversification approaches - pseudo or lazy-diversification. This is because they can give investors false comfort while setting them up for nasty surprises ahead. Let's go through them in order.

Some investors will often aim to diversify their portfolio holdings by increasing the number of securities they hold. The suggestion that appropriate diversification can be achieved by increasing the number of holdings has come from both the media and academia. Jim Cramer, on his Mad Money program, used to air a segment called "Am I Diversified?" where users called in with Jim's view of a 5-stock portfolio. Somewhat more seriously, in their 1970 paper, Lawrence Fisher and James H. Lorie found that a random portfolio of 32 stocks reduced the return volatility of the portfolio by 95%. This approach, while interesting, is not the same as diversification, however, and most investors are clearly well aware of this fact.

This is why investors also try to allocate across different sectors. However, apart from the CEF and utilities sectors which dropped by "just" 20%, all other sectors experienced very heavy drawdowns.

Source: Systematic Income Preferreds Tool

Tilting entire towards investment-grade securities is no guarantee of success either. The chart below plots total returns over the past month of investment-grade securities where drawdowns have ranged from low single-digits to over 60%.

Source: Systematic Income Preferreds Tool

In the sections below, we discuss additional dimensions of preferred securities that investors should consider in constructing their portfolios.

As we suggest above, allocating to securities from different sectors may not do the job, since a given sector can contain securities with very different characteristics. To take the mREIT sector as an example, the recent drawdowns within the sector have ranged between 40% and 95%. While 40% is a terrible result, it is surely miles better than 95%. In the case of this particular sector, the key differentiator lies in the underlying portfolio holdings of each company with companies focused on agencies performing better.

Source: Systematic Income Preferreds Tool

By definition, the individual institutional preferreds market is largely inaccessible to retail investors who are mostly limited to the $25-par market with a few exceptions. This doesn't mean that retail investors cannot hold institutional securities, however, with many preferreds funds allocating to the institutional space.

In the chart below, we plot the total returns over the last two months of the two markets. We proxy the two markets using two funds: the iShares Preferred and Income Securities ETF (NASDAQ:PFF) for the retail market and the First Trust Institutional Preferred Securities and Income ETF (NYSEARCA:FPEI) for the institutional market. This is not a perfect comparison, given the credit quality, regional, and industry differences, but the results are still telling. Initially, the two populations tracked each other relatively well, but then began to diverge sharply, with the retail population showing significantly more volatility. We suspect the lower liquidity of the retail space revealed more liquidity gaps in the trading and pushed the retail market nearly 10% below the institutional one at the lows. Although, in the end, the two sectors have again converged, the sharper drawdowns in the retail sector may have made it more difficult for investors to hang on to their holdings during the drawdown.

Source: ADS Analytics LLC, Tiingo

In the chart below, we plot the total returns of retail preferreds by dividend type: floating-rate, fixed-to-floating, and fixed. We exclude non-investment grade securities to control for credit quality. The chart shows that fixed-rate preferreds have held up the best, with fixed-to-floating suffering drawdowns similar to floating-rate securities but rallying harder since then.

Source: Systematic Income Preferreds Tool

This relationship makes sense for two reasons. First, fixed-rate preferreds have a higher duration, which is an asset in an environment of decreasing interest rates. And secondly, lower short-term rates due to sharp Fed cuts have lowered the distributions of floating-rate securities as well as reset yields of fixed-to-float securities in relation to fixed-rate preferreds. A steepening yield curve means that the prices of floating-rate and fixed-to-floating securities had to drop further in order for their stripped and reset yields to catch up to fixed-rate yields.

If we look at total returns of investment-grade fixed-rate securities by the amount of call protection, we see an interesting dynamic. Securities with the shortest amount of call protection have fallen the least, and vice-versa. This makes sense intuitively since the time to first call acts as a kind of conditional duration and securities with the least time to first call should have the lowest duration. And because the moves in credit spreads were much higher than moves in risk-free yields, the securities with the lowest duration were least impacted.

Source: Systematic Income Preferreds Tool

This only works up to a point, however, since the closer the company is to default, the more the prices of its pari passu securities will move towards the same price. You can see this dynamic in the corporate bond space when the yield curve will typically flatten and then invert at credit spreads of around 500-1000bps. This is because, when prices of bonds with different maturities move towards the same price i.e. recovery, the yields of shorter-term bonds will increase more sharply than the yields of longer-term bonds.

Let's take a look at a few fixed-rate preferreds issued by Bank of America (NYSE:BAC) to see if this dynamic is evident in preferreds as well. The Bank of America, 6.2% Series C (BAC.PA) has the least call protection with a call date in January 2021, and the Bank of America 5.0% Series LL (BAC.PN) has the greatest amount of call protection with a first call date in September 2024. As we would expect, the BAC.PA has moved much less than BAC.PN.

Source: Systematic Income Preferreds Tool

Let's see what happened in yield terms. The yields of the six stocks compressed through the drawdown and inverted during the worst episode and then normalized again. This jives well with the experience of the corporate bond market but also suggests that investors may be more willing to take a lower yield if they can lock in that yield for a longer period of time.

Source: Systematic Income Preferreds Tool

When constructing portfolios of preferred stocks, investors should look beyond the issuer count and sector representation. Taking into account such security dimensions as intra-sector quality, coupon-type and duration diversification, as well as institutional vs. retail representation should lead to more resilient portfolios that could potentially withstand a greater number of challenging market conditions.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Beware Lazy Diversification In Preferreds - Seeking Alpha