Preferred securities have garnered much attention in recent years from investors seeking meaningful yield in our persistent low interest rate environment. But now that the Fed has embarked on a self-described period of gradually raising interest rates, some investors are questioning how preferred securities will hold up in this environment.
What could happen to preferred securities now that the Federal Reserve has raised rates?
There are many forces in play that impact how any asset class, including preferred securities, will perform in a period of interest rate change. An analysis of these factors is vital when determining an appropriate asset allocation. However, we believe the fear that some investors are feeling over this uncertainty may be unwarranted.
Since 1994, there have been three periods of rising rates: February 1994 – February 1995, June 1999 – May 2000, and June 2004 – June 2006. These periods are noted in the graph below, which illustrates the total return of the preferred securities index since inception through the end of the last rate hike. While interest rates are by no means the sole determinant of preferred securities prices, the asset class did drop in value over the first two rate hike periods, while increasing in value during the last one – though in that instance they declined ahead of the official rate hike period.
Nevertheless, in each case the declines in preferred securities that coincided with interest rate hikes ultimately reversed. As the below chart demonstrates, the index recouped losses shortly after the rate hike periods ended. In fact, in each case preferred securities started coming back before the rate increases ceased. To the patient investor, when viewed over the long term, these periods of decline look more like “blips” rather than significant downturns – provided you remain invested.
Will this rate hike period be like the others?
While historical context can be helpful, no two periods are ever really the same. In terms of today’s rate hike period, the Federal Reserve has offered guidance on certain key variables:
- Magnitude: the full extent of the interest rate increase over the period
- Duration: the length of the rate hike period
- Number: the number of hikes over the full period
Ultimately, these variables are used to anticipate pace – whether a rate hike period will be quick and violent, or slow and gradual. While the future is never certain, we believe this rate hike will be more along the lines of the latter, and perhaps most similar to the 2004 – 2006 period. Similar to today’s environment, during this period the Federal Reserve was removing accommodative policy in a period of economic expansion and low inflation.They took their time raising rates in small increments over two years, and fixed income asset classes generally performed positively for the full period.
So what does this mean when investing in preferred securities?
As always, financial goals and risk tolerance levels, rather than the market’s short term reactions to Fed policy, should dictate overall investment strategy. While periods of decline are often painful when one is in the midst of them, we believe it’s important to keep in mind that the power of patience can reward long-term investors.
Markets will always go up and down, but portfolio changes should be based on long-term financial goals. If there are no changes to underlying financial needs and goals, we recommend caution in attempting any sudden asset allocation shifts.
BofA Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of fixed rate U.S. dollar denominated preferred securities issued in the U.S. domestic market. Securities must have an investment grade rating (based on an average of Moody's, S&P, and Fitch) and must have an investment grade rated country of risk (based on an average of Moody's, S&P, and Fitch foreign currency long term sovereign debt ratings).
This information is intended solely to report on investment strategies and opportunities identified by Roosevelt. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Please contact us at 646-452-6700 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions, or if you would like to request a copy of our Code of Ethics. Our current disclosure statement is set forth on our Form ADV Part II, available for your review upon request, and on our website, www.rooseveltinvestments.com.