Preferred Stock ETF Dodges High-Yield Mania

 

 

I often caution against running with the investing herd, especially when it comes to higher-yielding securities.

Well, Bank of America Merrill Lynch recently put out a report warning about “a cleansing drop in asset prices.” Sure enough, the popularity of various high-yield investments is one of the five potential catalysts – which the analysts have combined into an ominous C.R.A.S.H. acronym.

The report includes perhaps the most striking depiction of the “reach for yield” phenomenon I’ve ever seen…

Cumulative flows into dividend funds, master limited partnerships (MLPs), real estate investment trusts (REITs), and high-yield bonds have totaled $413 billion since 2002.

The popularity of these investments, along with the associated fund flows, has adversely impacted their risk-reward propositions. Returns are effectively pulled forward in time as investors chase prices higher, thereby lowering yields. Meanwhile, stock valuations become inflated, hampering performance.

For example, in July 2014, I noted that Procter & Gamble (PG), a Dividend Aristocrat, had become expensive relative to its historical valuation. Despite a nice yield and solid underlying businesses, the stock had underperformed since mid-2013 – and it continues to underperform.

Since my article, PG has gained 3.2% on a total-return basis (including dividends), compared with an advance of 9.1% for the S&P 500 (SPY). The stock continues to work off its high valuation, but many investors are complacent.

Indeed, high-yielding stocks and other “crowded trades” are particularly vulnerable if the herd was to get spooked, as BofAML has illustrated.

However, there’s one corner of the market that’s conspicuously absent from the above chart: preferred stocks. They’re perhaps the only higher-yielding assets which are truly out-of-favor.