No, Preferred Stocks Are Not a Replacement for Bonds

Typically I don’t spend much of my time attending investment and wealth management conferences. For the most part these events are just organized sales platforms for fund and insurance companies to pitch their latest products to advisors (who then turn around and pitch them to their clients).

Count me out.

However, I make exceptions if a sizable percentage of the content is academic research, for example, or if there is a greater emphasis on topics such as index investing or tax-efficient portfolio management.

Last week I decided to spend part of my Tuesday afternoon at the Private Wealth Mountain States Forum that was held here in Denver. I was invited as a guest speaker on a panel discussion entitled Fixed Income: Identifying Liquidity Risk and Finding Yield to provide some commentary and perspective on the bond markets.

With interest rates remaining persistently low, it wasn’t surprising at all that this topic found its way on to the forum’s agenda. Investors are clamoring for yield and turning to asset classes such as preferred stocks, REITs, and junk bonds to find it.

Likewise, I also wasn’t surprised to find myself playing the role of the “lone wolf” on the panel. While my panel colleagues were preaching the typical active management talking points of “picking your spots” and “avoiding overbought” assets, I did my best to serve as the voice of reason for those that were interested in listening.

My goal in attending was to hopefully save a few souls from being tempted by the allure of “outsmarting” the market (with the help of a high-fee manager of course). Reviewing my notes following the forum, I thought it would be helpful to share what I covered during my speaking time on the panel.

Remember the Purpose of Fixed Income in Your Portfolio

Yes, it’s true. Interest rates are historically low. That isn’t really breaking news. In reality, we’ve been in a declining rate environment since the early- to mid-1980s. The yield on the 10-year treasury is currently hovering around 1.60%. In 1981 it peaked at more than 15.0%!

Undoubtedly, declining rates have hurt savers and made it more difficult to earn a respectable income from “safe” investments. However, this fact pattern doesn’t change the primary role that fixed income should be playing in our portfolios. The first obligation of our bonds is to dampen the volatility of the stocks that we own and to reduce the downside risk of our overall portfolio. Don’t ever forget that!

Simply put, even for the most conservative of individual investors, it’s typically a poor idea to invest all of your eggs in the fixed income basket. Instead, it’s generally wise to include at least a small allocation to equities in our portfolio both for purchasing power protection (i.e. managing inflation risk) and for tax efficiency (stocks can take advantage of long-term capital gains rates).

Accordingly, while the majority of retirees would prefer higher interest rates for their bond investments, they are likely still reliant on the stock portion of their portfolio for countering longevity risk and keeping their tax bill in check. This leads me to my next point…

Yield is Not a Replacement for Principal Protection

Some investors assume that because a particular security or asset class has a “high yield” that by itself means that it can serve as a replacement for the existing bonds in their portfolio. This line of thinking varies of course, but a lot of investors have convinced themselves that a higher yield equates to greater safety for the investment.

Repeat after me: High yield is not a replacement for principal protection!

To illustrate this, take a look at the chart from Morningstar below (click to expand):

Preferred Stocks and Other High-Yield Asset Classes

The chart shows the performance from April 2007 to February 2009 for five ETFs representing the following asset classes:

  • High-yield bonds (HYG – iShares iBoxx $ High Yield Corporate Bond ETF)
  • US REITs (VNQ – Vanguard REIT ETF)
  • Energy Stocks (VDE – Vanguard Energy ETF)
  • Preferred Stocks (PFF – iShares U.S. Preferred Stock ETF)
  • US Bonds (BND – Vanguard Total Bond Market ETF)

As you can see, the “bond alternative” asset classes experienced declines ranging from 34.21% for energy stocks to 69.80% for US REITS. By comparison, the broad US bond market was not only quite stable, but it actually increased by a modest 2.15% during this same period.

I don’t know about you, but I’d much rather stick with even (very) low yielding bonds, than trying to add yield with an asset class that can decline as much or more than my stocks. Simply put, the very asset classes that many investors are chasing as they hunt for yield are the exact opposite of “safe bond equivalents.”

Don’t kid yourself otherwise.

A Total Return Approach is a Much More Efficient Way to Create Income

Lastly we need to remember that we do in fact have some control over when and how we take distributions from our accounts. There is no rule that says we must rely only on the interest-earning assets in our portfolio for income. Rather, we can use a combination of interest, dividends, and capital gains in order to generate the cash we need for withdrawals from our portfolio. This approach is what is commonly known as “total return” investing.

Let’s say, for sake of argument, that the combined interest and dividend yield for a $100,000 portfolio is 2% (or $2,000). However, our target withdrawal rate for the year is 3.50% (or $3,500).

Where does the additional money come from?

Let’s assume that in addition to the 2% yield (the income return), our portfolio also increases in value by a modest 3% (the capital return). To generate the additional “yield” we can simply sell $1,500 of our portfolio (hopefully at long-term capital gains rates) and then withdraw it, along with the $2,000 of interest and dividend income, in order to reach our $3,500 target.

Of course in some years our portfolio may actually decline in value. However, in other years our portfolio is likely to increase in value by much more than 3%. As a result, the strategy becomes to use the “excess returns” we get in the really good years to provide for withdrawals in the not so good years.

Ultimately, total return investing can be a much more flexible and tax-efficient path to generating portfolio income. Likewise, in a low rate environment, it may be the only path to provide the returns we need.

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