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It’s been a tough year to be a bond investor.
Well, technically, it’s been a tough year for every investor, but the interest rate environment of 2022 has been especially bad for bond investors.
Traditional portfolio management operates under the assumption of stocks and bonds being anti-correlated with each other, meaning that when one moves up the other goes down and vice versa. It also operates under the model of stocks being volatile while bonds are safe.
2022 has blown up both rules.
Year to date, the S&P 500 has gone down by about 15% for a variety of reasons like rising interest rates, the war in the Ukraine, and record high inflation. We don’t like it, but at least it makes sense.
Bonds, however, have completely failed this year in their role as a counter-balance to the stock market’s volatility. An aggregate bond index like VSB (Canadian) or BND (American) has fallen about 10%. What the Hell!
The reason for this is, of course, interest rates. When interest rates rise, the price of existing bonds fall, which is expected. What wasn’t expected, however, was all this stuff happening all at once. On multiple occasions, I’ve tried to write an article comparing 2022 to previous recessions in an attempt to reassure everyone that things will work out just fine, but I’ve had to abandon that article multiple times because I just can’t find a similar enough situation in the past. A pandemic, plus a war, plus high inflation, plus rising interest rates, plus a housing correction, all in one year? It’s never happened before. We are in uncharted territory here, people!
Which is both a bit scary and a bit exciting. Scary because without a clear historical precedent, it’s impossible to predict what will happen next. But a bit exciting because there might be opportunities that appear that don’t happen often.
I think we might be in that situation with preferred shares.
Now, before I dive into things, it’s worth repeating that this is not financial advice. I am just some dude on the Internet sharing his thoughts. Do with it what you will.
Preferred shares are more complicated than traditional stocks and bonds, and therefore not for everybody. But for people who have the time and interest to dive into these, they can be quite an interesting asset class.
For starters, preferred shares are neither equities nor bonds. They’re kind of a hybrid, and have qualities of both. Like equities, they’re issued by companies and trade on the stock market. Like equities, they also pay a dividend rather than interest, and can be used as a way to receive tax-advantaged income in retirement.
However, owning them doesn’t give you an ownership stake in the company like equities do. You can’t use them to vote at shareholder meetings (which few people do anyway).
Something that’s also interesting about preferred shares is that they can be issued as a fixed rate or as rate resets. Fixed rate preferred shares are, as the name implies, issued with a fixed interest rate that never changes, similar to a traditional bond.
Rate reset preferred shares, on the other hand, are issued with an interest rate that’s defined by a spread to the central bank’s benchmark rate. For example, a rate reset preferred share might be issued at the current 5-year yield + 2%. So when interest rates rise, rate resets will “reset” their interest rate higher to match, hence the name.
This makes rate reset preferred shares one of the few asset classes that should rise with interest rates. As interest rates rise, rate resets should hike their dividends, which makes them more valuable, which should make their prices go up.
Note that I said “should.” Because the reality has been quite different.
Since the beginning of 2022, as it became increasingly obvious that interest rates were going to go up around the world, I’ve been watching the preferred share market closely to see if they would behave the way I was expecting.
They did not.
Instead of going up with interest rates, preferred shares has gone straight down.
So what gives?
Here’s the thing. I’ve been searching for an answer for the better part of a year now, and I still haven’t found one. Preferred shares are typically issued by stable blue-chip companies like banks, insurers, utilities, etc, and if those companies were in trouble and defaulting on their payments, that might explain the sudden drop in price. But no banks or utilities are falling over right now, so that’s not it.
The only explanation I was left with is that the price drop in preferred shares is irrational and way oversold.
Here in Canada, preferred shares are mostly owned by unsophisticated retail investors, so it’s entirely possible many of them panicked as the stock market dropped and simply sold everything and moved to cash. It’s also entirely possible that retail investors aren’t understanding the difference between fixed-rate and floating rate preferred shares, because both asset classes have been going down this year when they should be going in opposite directions.
As a result, I think floating-rate preferred shares are underpriced right now.
Now, don’t get me wrong. I’m not trying to outguess the market here. I have no idea when or even if this asset class will “snap out of it” and start rallying like they’re supposed to. So on it’s own, this doesn’t make preferred shares an attractive opportunity.
What does, however, is their yield.
Even while prices have been falling, rate resets have been quietly resetting their rates as advertised. This has caused the yields on an ETF tracking rate-reset preferred share like ZPR to slowly rise over the year.
During the pandemic, a Canadian floating-rate preferred share ETF like ZPR was yielding around 4%. Not bad, but not too crazy. Over time, however, that yield has been going up as interest rates have risen.
I haven’t seen a yield that high for preferred shares in…well…ever! A 6% yield is usually reserved for super risky investments like junk bonds, but ZPR shares are issued by stable blue-chip companies in no danger of going into default. And given that a traditional bond index is yielding only 3.5% while also not providing the stabilizing anti-correlated effect they’re supposed to, what exactly am I giving up that extra potential yield for?
Why This Makes Sense For Retirees
Now, to be clear, owning preferred shares doesn’t make sense for everyone. If you’re still in the accumulation phase of your FIRE journey, stick with plain vanilla stock and bond index ETFs. The added complexity isn’t worth it if you don’t need the income, and for that reason my recommendations in the Investment Workshop haven’t changed since the Workshop is directed at newer investors who are still working.
However, if you’re retired (or close to it) and looking to build up (or enhance) your Yield Shield, then this move might make sense. This is my current portfolio’s yield.
Note that the Income column is calculated by taking the asset class’s yield, multiplying by its allocation, then multiplying by our portfolio’s current total value of $1.8M. Adding up this column gives us our total portfolio income in the bottom right corner.
This is Portfolio A, which is set up as a 90% equity/10% fixed income split. This may seem aggressive for an early retiree, but as our analysis showed us at the end of 2021, because our portfolio has grown so much since we left, we can tolerate a lot more volatility now than when we first retired while still maintaining a 100% success rate on FIRECalc.
Now let’s see what happens when we add preferred shares to the mix by selling our short-duration bond fund and adding in a preferred share index yielding 6%.
My income jumps to $62,316, so it goes up 11% just from this change. And honestly, bonds aren’t doing a great job of shielding me from volatility right now anyway.
Another option is to adjust this mix to a more even 75% equity/25% preferred shares allocation, essentially making all 4 asset classes equally weighted. What does this do to my yield?
My portfolio yield now rises to almost $70k!
I gotta admit, that’s pretty tempting. With this mix, I’m still aggressively invested in traditional index funds. I’ve gotten rid of bonds, so my portfolio is going to be more volatile (but again, I’m OK with this), and my yield of $70k is completely based on dividends, which are tax-free due to the dividend tax credit. So I get a raise in income, and my tax burden goes down at the same time!
While I was working and saving for retirement, I invested completely passively and just rebalanced to my targets every month while ignoring the news. It was simple, and it worked.
In retirement, however, I’ve found my investing strategy subtly change. Rather than focusing on controlling our portfolio’s volatility, we’re finding ourselves more focused on our portfolio’s yield, since that’s what we actually need to live on.
As a result, we’re not really spending any time following the stock market, and instead watching out for deals in the fixed income and Yield Shield assets. And right now, Preferred Shares are flashing “DEAL! DEAL! DEAL!” to us.
What do you think? Do you think it’s a good time to invest in Preferred Shares, or do you think there’s still more room to fall in that asset class?
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