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As every investor knows, securities that offer a fixed yield underperform when interest rates rise and perform better when interest rates fall. The extent to which a security's price responds to changes in the interest rate environment is determined by the measurement of duration.
In fact, I did two things at the beginning of 2022 because I expected interest rates to rise.
I renewed my mortgage at a fixed rate of 2.75% (due 2027), which is way less than what my ex-girlfriend is paying for her new house 🙂 I bought a ton of Invesco Variable Rate Preferred ETF (NYSEARCA:VRP).
The duration of a bond roughly approximates its maturity date. In fact, for zero-coupon bonds, duration and maturity date are equal, but for securities that pay coupons (or dividends), duration will be shorter than maturity date, but usually close (unless the coupon is very high). For example, for the Vanguard Intermediate Corporate Bond ETF (VCIT), Morningstar reports an effective maturity date of 7.4 years and an effective duration of 6.13 years.
On the other hand, VRP, despite having a large number of perpetual preferred shares, has an effective life of only around two years, because the dividends paid on the floating rate preferred stock are adjusted according to the interest rate environment.
Given this, it is likely that VRP would have outperformed VCIT in a rising interest rate environment.
Data by YCharts
It may be more appropriate to evaluate the VRP against the Invesco Preferred ETF (PGX), iShares Preferred And Income Securities ETF (PFF), and First Trust Preferred Securities and Income Fund (FPE).The chart below again shows how the VRP has performed well in a rising interest rate environment.This is because the short duration due to the volatility of the securities it holds protects it against rising interest rates.
Data by YCharts
Not only did the VRP protect me from losses, but it also achieved a compound annual growth rate of approximately 3% over the period. All of the above examinations are for the period beginning January 1, 2022.
The fear of sector exposure
I held the majority of my VRP purchases during that period, but there were moments when I felt uneasy. Investors in preferred stock ETFs need to understand that the majority of companies that issue preferred stock are financial institutions, and that the fund they hold may not be as diversified as they would like.
Financial sector issuers make up roughly three-quarters of VRP’s holdings, so when Silicon Valley Bank collapsed last March, we discovered that winter sledding season wasn’t over yet. The entire financial sector was put on notice (no pun intended) that even seemingly safe investments like preferred stocks could be at risk if the crisis snowballed. After all, when the 2008-2009 financial crisis began with a few small bankruptcies, the market at large did not anticipate that such contagion could occur.
So when VRP took a big hit in March 2023, I felt the need to reallocate some of my holdings elsewhere, despite the losses. I discovered the VanEck Preferred Securities ex Financials ETF (PFXF), which as the name suggests excludes exposure to financial institutions.
Data by YCharts
This safe diversification away from the VRP has cost me some profits. The VRP is up over 18% (total return) since that point, nearly double the return of PFXF. That being said, I do not regret the decision to reallocate some of my VRP holdings. A good decision is a good decision no matter what the outcome. Given the unknown risks to finance in the spring of 2023, I made the right call. Part of the VRP's outperformance is also due to the floating rate nature of the ETF.
I'm looking forward to
As mentioned earlier, duration is a big handicap when interest rates (or more accurately, yields) are rising. But the opposite is true when interest rates are falling. Bonds, preferred stocks (fixed dividend yields) and ETFs that hold these have greater duration exposure and can reap greater benefits when yields are falling.
But the outlook for VRP is different: if interest rates fall, the interest rates earned on these floating rate preferred securities will reset lower.
Data by YCharts
I haven't kept as much tabs on the VRP holdings as I should have in the past, but I'm pleased to note that their year-to-date performance has been strong and they've actually outperformed the fixed interest benchmark preferred stock ETFs.
No wonder investors are doing a double take here: yields are falling, right?
Now, there are a few reasons why VRP has continued to perform well so far in 2024. First, while it is true that Treasury yields have fallen, most of this is in short-term Treasury bills, with the 2-year Treasury yield remaining higher than it was at the start of the year.
But there's no guarantee that a fall in yields will hit VRPs, at least not immediately. Why is that?
Recall that Morningstar reports the VRP's effective duration as 2.01, which basically means that the ETF's underlying securities have an average of two years of interest rate risk. We also expect most of the VRP's preferred stock holdings to undergo an interest rate reset pegged to SOFR (Secured Overnight Financing Rate).
Therefore, we can expect that any preferred stock issuances (if any) held by VRPs that are scheduled to have interest rate resets this week will reset at a higher dividend rate than they currently earn. Even if the FOMC cuts interest rates several times over the next six months, this will not necessarily result in lower dividend levels for floating rate preferred stock held by VRPs. It all depends on when the last reset occurred.
Let's look at a specific security: 4.6% JPM Preferred Stock issued on January 23, 2020. This security actually pays a fixed 4.6% dividend rate currently, but will transition to a floating rate on February 1, 2025, likely resetting to SOFR +3.125%.
SOFR is currently around 5.3%, and this JPM preferred stock issuance would pay a dividend rate of approximately 8.425% (5.3% + 3.125%) if it reset today. If the FOMC cuts rates by 1.00% by early 2025, this JPM preferred stock issuance is expected to reset at a dividend rate of approximately 7.425%.
This particular security seems somewhat unusual, but the example is compelling: the JPM preferred stock issue reviewed here is all but guaranteed to pay a higher dividend rate when it resets on February 1, 2025, no matter how much the FOMC cuts rates by then. And a higher dividend rate means the dividends earned by the VRP will also be higher.
Thus, a falling interest rate environment would not necessarily immediately undermine VRP performance.
Summary and Recommendations
A few days ago I was pleased to take the time to take a closer look at the Investor Variable Rate Preferred ETF, which makes up a significant portion of my income portfolio. I was a little worried about what I would find, and had already announced that I was looking for an alternative to the VRP.
I am not worried about a collapse in VRP's dividend and market valuation, at least in the short term. The FOMC is expected to cut the fed funds rate by 0.75% by early 2025, and only then could (some of) VRP's holdings start to reset to dividend rates equal to or lower than what they currently earn.
I intend to hold VRP through at least the end of the year and rate it a Buy. Based on the most recent monthly dividend of $0.1093, the ETF yields 5.4%, however I expect further resets in the coming months that could see the dividend recover to $0.115-0.120 per month and the yield approach 6%.
risk
The U.S. economy is showing signs of slowing, which could lead the Federal Reserve to decide to cut interest rates faster — which would be great for fixed-income preferred funds, but not at all for VRPs.
Also, as mentioned above, the VRP is heavily weighted towards preferred stock issuances in the financial sector. A major financial crisis or concerns about the solvency of financial institutions could cause investors to flee these securities, causing the value of the VRP to decline.