Managing Interest Rate Risk in a Preferred Stock Portfolio

Interest Rate Signs Increasing in Size | Managing Interest Rate Risk for Preferred Stock Income | Sheaff Brock Investment Advisors

Managing Interest Rate Risk in a Preferred Stock Portfolio

If I invest in preferred stock for the income just when interest rates are rising, won’t I be setting myself up for losing money? “Not necessarily,” contends JR Humphreys CFA, CAIA, Senior Portfolio Manager at Sheaff Brock Investment Advisors. Humphreys explains that, “increasing interest rates is usually the result of an improving economy that could lead to credit rating upgrades for the preferred equity, resulting in a higher price.”

Many investors have the perception that preferred securities are highly interest-rate sensitive. But the preferred market, Humphreys emphasizes, is actually composed of securities with a variety of structures that, when actively managed, can help to mitigate the impact from rising interest rates. One example is floating rate securities, which effectively have a near-zero duration because they reset frequently based on movements of a benchmark interest rate.

Sheaff Brock Senior Portfolio Manager JR Humphreys stresses that using fixed- to floating-rate preferred stocks lowered the duration of the securities, increasing cash flows as interest rates increase. Since preferred equity, unlike bonds, has no final maturity date, he says, the use of callable preferred securities can help shorten the duration and reduce interest rate risk.

In fact, the Sheaff Brock Preferred Income portfolio, an actively managed strategy with the primary goal of generating income, utilizes several tactics in managing preferred equity in an increasing interest rate environment. Humphreys outlines three tactics of active management in order to manage interest rate risk:

  1. Higher coupons and thus higher preferred prices will lower the duration because of the greater cash flows.
  2. By shortening the maturity, the duration will fall. However preferred equity, unlike bonds, does not have a final maturity date so the use of callable preferred can help shorten the duration.
  3. Using fixed to floating rate preferred and floating rate preferreds lowers the duration by increasing the cash flows as interest rates increase.

So, as the search for precisely the right stock/bond portfolio mix continues for investors, Sheaff Brock Director Jim Murphy recommends introducing the “hybrid” element—in the form of preferred stock—and going beyond the old traditional 60/40 pie chart by allocating a portion of retirement portfolios to preferreds.

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