Hybrids Could Be the Income Solution

The vast bulk of our portfolios is made up of common stocks and bonds. And we pretty much know what we own when we choose these asset classes. When you buy a share of Coca-Cola, you are buying an ownership stake in the company. When you purchase a 10-year Treasury bond, you are essentially lending the U.S. government money with a promise to pay you back plus interest.

Stocks are ownership. Bonds are loans.

Nonetheless, modern finance has created some securities that blur the line between bonds and stocks. Both preferred stock and convertible bonds offer bond and stock-like attributes within one ticker.

Preferred stocks (or preferreds) feature much higher yields than their common stock sisters, often in the 4% to 7% range. Just like bonds, these shares are issued at a certain amount called par value – usually $25 or $1000 per share. After a certain date, an issuing company can call the security and investors will receive the par value for their shares, providing a price floor for the preferred stock and making them very bond-like indeed.

However, they also function much like stocks. Based on demand and market forces, preferred stock can be issued at premiums or discounts to their par value, allowing for potential capital appreciation. Additionally, preferred stock is considered senior to common stock in the event of liquidation/bankruptcy. Preferred shares have priority over common stockholders on earnings/assets as well, and dividends must be paid to preferred holders before common shareholders. As a result, all of these factors dampen their volatility.

Convertible bonds (or converts) are very similar but offer a few major differences. The best way to think of them is a bond with a hidden stock option tucked inside. Just like regular bonds, convertible bonds come with a par value, coupon payments and a high place in the bankruptcy ladder. However, the issuing firm has the right to exchange the bond for shares of its own stock under certain conditions. This allows investors to get steady bond-like income and the ability to gain from a rising stock market.

Don’t forget to explore all convertible bond funds here.

For one thing, the duo offers lower overall volatility than both the equity and similarly yielding bonds like high-yield/junk-rated debt and that primarily comes from their unique features and higher priority in the capital structure. Over the last ten years through the end of 2021, the Bank of America Perpetual Preferred Index has produced volatility of 5.63%, compared to the 13.10% for the S&P 500. A similar difference for preferred exists when compared to junk bonds.

In addition to being less volatile, hybrids may offer some protection versus rising rates.

For preferreds, there was a dip after the Fed first began raising rates. However, after so-called “yield tourists” left the market, investors were drawn to the asset type due to the calming effect of the par value and high yield scenario. Check out the pros and cons of preferreds here.

Converts on the other hand tend to do very well in a rising rate environment. The reason being is that their value is determined by their underlying equity price and many firms will exchange their stock into shares during these periods to avoid higher interest rates. The end result is very strong returns in rising rate environments. According to convertible bond specialist Calamos, in the ten periods of rising rates during the last 20 years, converts have outperformed both bonds and the S&P 500 by a wide margin.

Finally, yields on hybrids are pretty juicy right now, with preferreds paying close to 6%, while converts are just over 3%. An additional benefit is that many preferred stocks’ payouts meet qualified dividend definitions and come at lower tax rates.

Given their ability to generate high income with a dose of lower volatility and rising rate protection, investors may want to consider adding a dose of hybrids to their portfolios. The tricky part used to be getting exposure, as hybrids have been historically hard to research and purchase by individual investors. However, the ETF boom has made adding the asset class easy to do.

The two biggest funds on the block, with $4.4 and $14 billion, respectively, are the SPDR Bloomberg Convertible Securities ETF (CWB) and iShares Preferred and Income Securities ETF (PFF). Both funds track indices of their respective hybrid securities with hundreds of different holdings. Each features hefty trading volumes and low expenses.

Additionally, there are plenty of active mutual funds that target the sector. This includes the top-rated Nuveen Preferred Securities & Income (NPSAX) and Fidelity Convertible Securities Fund (FCVSX).

In the end, hybrid securities like preferred stock and convertible bonds could be great choices for investors looking to avoid interest rate risk, reduce volatility and boost their portfolio’s yield. The best part is that there are plenty of low-cost options to access the once hard-to-reach market sectors.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.