Q: Can you capture higher returns on a municipal portfolio by lowering its credit quality?
A: Investors generally demand a higher yield when purchasing lower-credit-quality municipal bonds due to their greater risk. The assumption is the greater the risk, the greater the expected return. However, evidence has shown that investors have not realized higher risk-adjusted returns by denigrating credit quality. For investors seeking a higher return, we prefer to slightly tilt the portfolio allocation to a higher equity component rather than adding municipal credit risk.
History has shown A-rated municipals have not had significantly higher returns when compared with AA-rated munis. The below example shows the returns of two similar portfolios over a 20-year period (1994–2013). Portfolio 1 comprises 60 percent equity/40 percent A-rated municipals. Portfolio 2 slightly tilts to a 2 percent increase in equity allocation but holds only AA-rated municipals. The total return and compounded returns are almost identical, and the portfolio tilting toward stocks actually had a slightly lower volatility and performed better in the down year of 2008.
|
1994–2013 |
Portfolio 1: |
Portfolio 2: |
Portfolio 3: |
Portfolio 4: 66/34 w/ AA-Rated Munis |
|
Avg. Monthly Return |
8.2 |
8.2 |
8.3 |
8.4 |
|
Compound Return |
7.4 |
7.4 |
7.3 |
7.6 |
|
Volatility |
12.3 |
12.2 |
13.6 |
12.9 |
|
2008 Performance |
–25.9 |
–24.4 |
–32.0 |
–26.0 |
We examine the effect of lowering the credit quality even further to BBB-rated municipals in Portfolio 3, again using a 60/40 equity-to-fixed allocation over the same period. This portfolio has significantly higher credit risk, but the returns were almost identical to Portfolios 1 and 2 but with a significant increase in volatility. In addition, the 2008 performance was considerably worse, showing these lower-rated bonds behave like equities at the wrong time.
Rather than sacrificing credit quality, another option is to tilt to a higher equity allocation for a similar portfolio return. Portfolio 4 moves to a 66 percent equity/34 percent AA-rated municipal allocation. The returns were higher, and the volatility and correlation to equities were lower.
It’s important to remember that one of the primary purposes of fixed income securities is to provide stability to investors’ portfolio. It is this stability that allows them to take equity risk.
Data supplied by Barclays. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. 60/40 w/ A-rated muni: 67% S&P 500/33% MSCI EAFE; 62/38 w/ AA-rated munis: 41% S&P 500/21% MSCI EAFE/38% Barclays US AA-Muni Index; 60/40 w/ BBB-rated munis: 67%/ S&P 500/33% MSCI EAFE; 66/34 w/ AA-rated munis: 44% S&P 500/22% MSCI EAFE/34% Barclays US AA Muni Index.
Copyright © 2014, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.
Q: What are the characteristics of preferred stocks?
A: Preferred stocks can be viewed as a hybrid of stocks and bonds. Preferred shareholders receive preference over common equity holders (hence the term “preferred”) for dividend payouts and in the event of a Chapter 11 bankruptcy filing. However, all debt holders would be paid before any payment would be made to the preferred shareholders. Unlike with shares of common stock, which may benefit from a company’s potential growth, the investment return on preferred stocks is usually a function of the stock price and/or the fixed dividend rate (although there are some variable preferred stocks). The following are other characteristics of preferred stocks:
Longer maturity: Preferred stocks are generally perpetual or long term. The historical evidence on fixed income investing shows that longer maturities have the poorest risk-reward characteristics — the lowest return for a given level of risk (with risk being defined as volatility, or standard deviation). Longer-term maturities with fixed yields do provide a hedge against deflationary environments. The problem with long-maturity preferred stocks is that the call feature negates the benefits of the longer maturity in a falling-rate environment. Thus, the holder does not benefit from a rise in price that would occur with a non-callable, fixed-rate security in a falling-rate environment.
Call risk: If rates rise, the price of the preferred stock will fall. However, if rates fall, the issuer could exercise the call feature to replace the preferred stock with an option that has a lower rate, has less-expensive conventional debt or perhaps is even equity. Investors get the risk of a long-duration product when rates rise, but the gains are limited. Having protection from calls is important to income-oriented investors because callable instruments present reinvestment risk, or the risk of having to reinvest the proceeds of a called investment at lower rates.
Cumulative vs. non-cumulative risk: Investors should be aware that in times of financial distress, preferred dividends could be deferred. It is also essential to understand that unless the preferred is a cumulative preferred, the company is not obligated to make up the missed dividends. Cumulative preferred stock must make up for missed dividends before declaring any dividends to common stockholders.
Other considerations: There are no low-cost index funds or passive funds to help investors diversify the credit risks of individual issuers. Buying individual issues involves trading costs, a lack of diversification and the need to regularly monitor credit ratings. Because of these factors, instead of purchasing preferred stocks, a better option is to use high-quality short- to intermediate-term bonds in order to provide both cash flow and diversification for the overall portfolio.
Copyright © 2014, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.
Investors tend to think of hedge fund managers as the superstars of the financial world. Collectively, it’s estimated they now manage somewhere in the neighborhood of $3 trillion. Unfortunately, their reputation hasn’t translated into the type of returns that live up to all the hype.
As we’ve continued to demonstrate over the years, the hedge fund industry has had a hard time keeping up. In fact, over the last 10 calendar years, 2004-2013, the HFRX Global Hedge Fund Index underperformed every single major domestic and international equity asset class. It even managed to underperform one-year Treasury notes, let alone longer-term Treasurys.
Despite this abysmal performance, marketing hype and hope is triumphing over wisdom and experience. Money continues to pour into hedge funds. It just goes to prove Abraham Lincoln’s belief that you can indeed fool some of the people all the time.
Read the rest of the article on ETF.com.