Preferred ETFs, with Rohan Reddy of Global X ETFs

Stewart: Welcome to another edition of the InsuranceAUM podcast. I’m Stewart Foley, I’ll be your host. Welcome back. We’re so happy to have you. Today we’re going to be talking about preferred stocks. And we’re joined today by Rohan Reddy, director of research for Global X ETFs. Rohan, thanks for being on, man. Thanks for taking the time.

Rohan: Absolutely. Great to be here. Stewart.

Stewart: We don’t talk about preferreds a whole lot on our show, so we’re thrilled to have the opportunity to cover that topic today. Before we get going too far, and I kind of tipped you off on this question a little bit, we’ve kind of changed our icebreaker questions. So we’ll start off like this. What’s your hometown, the one you grew up in, your first job of any kind, and what do you think makes insurance asset management cool?

Rohan: Okay. What a set of questions to get it started. So the first one, my hometown. I’m from Livingston, New Jersey. So I currently am in the New York City area, but I’ve been in the tri-state area my entire life. The mascot was the Lancers actually, so that was our team name in high school. In terms of my first job, I was actually working in a financial advisor’s office at Merrill Lynch, so I got to know a little bit of the business through the ground up, and so it gave me a deeper appreciation. Now I’m in ETFs and working with wirehouse companies.

And what makes insurance asset management cool? Well, I always find that insurers, in the way that they manage their portfolios, are quite interesting actually. So I went through the CFA program and they always described the way that insurers would manage portfolios in kind of a different light than a lot of different other institutional asset managers. And I always found that the balancing of risk and how the inner workings of asset management at the insurance level, which a lot of us use insurance policies in our day-to-day lives, and I found it to be quite an interesting experience to learn about the way that they manage their books.

Stewart: That’s fantastic. I like this question. I think this is going to stay. Well, you and I have something in common, a couple of things. One is, there was another school in my high school’s conference, they were also the Lancers, and that’s kind of cool. And I also worked at Merrill Lynch as a financial advisor, like 500 years ago. So good stuff.

Rohan: Oh, and third, we’ve got the CFA.

Stewart: Yeah, we got the CFA. Yeah, so that’s good. So if you could, just for our audience to level set, can you give us an overview of preferred stocks, really in terms of the coupon structures and the big crayons on preferreds? Before we get into the details around relative value.

Rohan: Yes. So to back up at a high level, preferred stocks, they’re a somewhat smaller part of the overall securities universe. They’re very similar, I would say, in some ways to fixed income securities, but they also display characteristics of standard equities. So that’s why they’re actually classified in this unique bucket as hybrid securities. They typically behave a little bit more like fixed income securities as opposed to equities, but they have a couple of characteristics in common. They do pay coupon payments even though they’re not necessarily bound to, quite like a true fixed income security is. They’re a little bit lower on the credit ladder, so they fall above common equity but below bonds. So that’s again why they fit into this hybrid category. And they’re typically offered by financial institutions most often, but a number of different sectors can offer preferreds as part of their capital planning in just the way that they raise capital.

So in terms of what makes them, I think, a little bit different than others, as you alluded to, they do have a few different coupon structures, and also the way that they trade and who invests in them can be somewhat different than other parts of even the bond market. So you have three categories of coupons. There’s fixed coupons, fixed-to-float coupons, which are often known as variable rate. And then you also have floating rate coupons. Fixed rate coupons, what they do is, they pay a fixed rate for the life of the preferred, and typically a lot of these preferreds are perpetual in issuance, but they can also be called at certain dates. So that is another feature of preferreds. Fixed-to-float preferreds. What these do is, basically for the initial part of the life of the preferred, usually about 5 or 10 years, they will pay a fixed rate and then after that they can either be called back by the issuer or they can enter this floating rate period where it’ll be tied to, say LIBOR, plus a credit spread for example.

And so that’s often how in some cases when rates are rising, you might benefit from higher coupon payments that come out of that. And then a smaller part of the preferred universe is floating rate preferreds. It’s definitely smaller than the other parts of the market, but you have basically these instruments that are tied to, say LIBOR. And then the credit spread components are very similar to the back half of a variable rate preferred offering, but that’s the way that they are through the life of the coupon. The fixed rate preferreds have the highest level of duration, fixed-to-float are in the middle, and then floating rate preferreds would have the lowest.

Stewart: That’s really helpful. And so can we talk a little bit about the outlook for the preferred stock market in the current macro environment, and why investors may want to be considering preferreds now?

Rohan: Yeah, and I think it’s a question we often get a lot from our clientele, which is “Where do we stand currently in the economic cycle?” Because that’s going to influence where markets start to move. So we’re of the belief that we certainly are in the latter stages of the cycle. It’s been a decade+ bull market that we’ve seen, and certainly we’ve seen some trials and tribulations and up markets and down markets, but generally markets have trailed upwards. And so we do believe that we’re starting to reach towards the end of that stage, not necessarily imminently, but at least at some point where we’ll start to see markets slow down. And even though this year has been a very good year, you see in major tech indexes like the NASDAQ 100, up over 35% for example, year-to-date, the S&P is up 14%, and then small caps are up around like 4% or so.

So a lot of it is indicative of a mega-cap led market that we’ve seen so far, but we do believe that there is going to eventually be some sort of a slowdown, not necessarily a recession by any means, but at least a slowdown in growth. And earnings expectations are also figuring that in where you saw a period last year and the year before that, especially in the post-Covid period, there was a lot more positive earnings growth and now it’s starting to level off. And so we do believe that even though it is going to be somewhat more of a lower growth environment going forward, in fact preferred stocks are well positioned for that because they’re not necessarily growing quite like common equity is looking to grow. They’re simply looking to pay out coupons to their, in this case, preferred stockholders.

And also we have seen that right now you’re talking about relative valuation, right? In the periods where interest rates were very low, at zero levels like we saw during this cycle, that’s when valuations and preferreds were a little bit more stretched. You saw like 0% yield to worst for example. Now preferreds have on average somewhere around a 7% yield to worst, which is pretty good relative value, all things considered. And yes, looking at where the yield curve is shaped right now, you do have short-term rates that are yielding 5%, but again, what’s the trade-off? Because we speak about relative value from a total return standpoint, and you’re also getting the coupon on top of that. So even tactically right now, as well as strategically, for income investors, there is a benefit to using preferreds in a portfolio.

Stewart: And we’re talking about avenues of accessing preferreds, right? So as an insurance investor, what are the ways I can get access to this market and do I want to be doing it actively or passively?

Rohan: There’s a few ways you get into this market. There is buying the individual issuances themselves, which is a little bit more common amongst the retail investor community or those who maybe follow certain issuances and preferreds. There is also ETFs and mutual funds out there, which is becoming increasingly popular just because a lot of these issuances tend to be either over the counter, or those that are exchange listed, they might have lower liquidity. So packaging all of that into an ETF or a mutual fund gives the investor a way to access the preferred stock market while not necessarily having to deal with some of the lower liquidity issuances out there, or the risk of picking individual names.

The third is, you could also have separately managed accounts, which is another common form that some institutional investors out there look to use in either preferreds or otherwise. But we do think that the ETF wrapper is actually quite valuable for investors these days because you are getting access to a liquid basket of securities in a pretty diversified manner. A lot of times these funds might be market-cap-weighted. And to your question about active versus passive management, there is the risk with active management that you could see, for example, the entrance of lower liquidity or riskier names coming into those portfolios. For example, as we saw with the AT1 issuances with Credit Suisse, for example.

And then also you might see some risk on names in other more riskier parts of the preferred market entered portfolios. By accessing an ETF that is passively managed, you basically get beta access to these markets and you can express your views on different points. So for example, we have a couple different funds out there. PFFD is one, and also PFFV, where one, PFFD is more of a beta tracking vehicle that invests in basically the liquid and investible universe of preferreds. It does lean a little bit more towards some of the fixed rate issuances. And then we also have PFFV, which is more focused on the fixed-to-floating rate issuances. So it depends on your views, for example, of duration. But the ETF universe has gotten built out enough now where preferreds are able to be expressed in a couple different manners.

Stewart: And when we think about the ETF space with insurance companies, obviously the NAIC rates their holdings and assigns a capital charge. And so in the case of ETFs, it’s possible to get look-through where the insurance company is being charged, based on the underlying holdings of the ETF, as opposed to an equity charge, that would be the way the ETF itself would be charged. Has Global X ETFs gone through that process of getting your funds rated to this point so that insurers can get the more favorable treatment?

Rohan: Yes. And so we’ve been starting to cover a lot more of our institutional investors, including our insurance company partners and clients a lot more closely. Part of it is because the ETF market has grown quite a bit and the adoption and education around ETFs and usage, even amongst more sophisticated investors, has picked up. So actually earlier this year we had three funds that we did use NAIC ratings for. So our fund PFFD that we mentioned is a 3B. PFFV is a 4B, and then we have an actively managed emerging market bond product, Ticker EMBD, that is rated 3C.

Stewart: That’s very helpful because those ratings really matter to our listeners. Can you talk a little bit about how I can use the fixed and the floating rate preferred ETFs within a portfolio? So for example, if I have a duration target, or I want to change my duration profile, how can I go about doing that? Am I blending the two or am I…? Tell me about the structures of one versus the other.

Rohan: Yes. So our fund, PFFD, is meant to be more an encompassing universe of these preferred issuances, which, it makes up the universe of exchange-listed preferreds. So there’s two buckets of preferreds out there. You have $25 preferreds, which leans fixed rate, and then you also have these $1,000 preferreds, which are usually over-the-counter. And so more actively managed funds tend to use those just because, similar to maybe corporate bonds for example, they may find value in that over-the-counter universe. So ETFs tend to lean more towards the exchange-listed universe, and our funds do the same thing as well. So on PFFD, for example, what we do is we basically invest in a lot of the largest, most liquid exchange-listed preferreds out there. And so it tends to skew majority fixed rate. And so the duration of that, actually, I’m pulling this up now, is right around 5.3 years on PFFD, and on PFFV it’s 1.4 years.

So the real reason why PFFV has some duration involved is because a lot of the securities in the portfolio are fixed-to-float and they might be in that fixed part of the lifecycle that is undergoing when you have the fixed-to-float rate preferreds out there. So in terms of how to blend these in a portfolio, what you could do is you could either express tactical market views. So in some cases, for example, if you believe that rates are going to go up, maybe you might lean more towards PFFV, just a lower duration risk in a portfolio, and also maybe even to benefit from higher coupon levels that you might collect.

So right now, for example, PFFD is yielding around 6.5%, and PFFV is yielding 6.9%. So there’s a little bit of a benefit from investing in some of these fixed-to-float preferreds right now. But if you believe that rates are going to move down, either because for example, you think the Fed is going to stop maybe their rate hiking regime or eventually undergo a rate cut later on, that might be where you might want to take on a little bit more duration risk. And so that’s how investors might consider using PFFD and some of those more fixed rate perverts.

Stewart: Yeah, just to timestamp this, on Monday, the 26th of June, the afternoon. Just so that if you’re going to quote anything, I want to make sure we’ve got it timestamped so that it stays and we all know where we are. Liquidity is something that comes up when I’m speaking with CIOs, and in the public markets and private markets, when there’s market dislocation, you can have episodes of limited liquidity depending upon the asset class. So how would you characterize the liquidity in the preferred market, and has there been anything over the last few months that has caused a dislocation?

Rohan: Yeah, certainly some of the smaller issuances might be a little bit less liquid, but we do believe that both product construction and the way that you invest in preferreds can be important. So I mentioned before that there were these over-the-counter preferreds, or if you don’t necessarily use a market cap weight approach to it, that’s where maybe you can fall into some liquidity issues and also certain individual issuances. So part of the reason why ETFs and funds have become more popular is because some of this liquidity risk can be managed just through product construction or just by the nature of using the actual ETF itself. Where in some cases, and we’ve seen this also in the bond market too, an ETF might be a little bit more liquid in some of these underlying securities themselves. So that is one way to mitigate some of the liquidity risk.

But we also do see that, for example, if you look at currently today, yes, there was the issues with the regional banking sector a few months back, we do think a lot of those risks have been absorbed currently by the market. But it certainly does make, when you have these volatile events occur, some buyers step away from the market. And so liquidity can dry up a little bit. That being said, going back to the point about using more of a liquid fund structure, that can be mitigated somewhat by using a more liquid fund, where you might actually see volume move up or down accordingly, depending on which investors might want to express views. For example, in ETFs, you can use options on ETFs. So again, there’s a lot more dynamic of a use case. And so it’s not always the case, where in other parts of the market you might see a fund structure be a little bit more liquid than the underlying securities, but in this case, at times it can actually be a benefit to use an ETF as opposed to single securities themselves.

Stewart: Rohan, that’s really helpful. So as a CIO, are there any special tax considerations that I should be aware of with regard to the dividends coming off preferreds?

Rohan: Yeah, so in some cases, a lot of times these preferreds will have qualified dividends, so QDI might be associated with them, so it might be classified as qualified dividend income. There is also, for some buyers, you might actually see what’s known as a dividend received deduction, so known as a DRD, in some cases. So there are some after-tax benefits that might come with preferreds as opposed to using, for example, fixed income, where you might be taxed fully at ordinary rates.

Stewart: I wanted to ask you, there’s times in various markets where things get to be headline risk, if you will, and a lot of boards seem to be asking about exposure to regional banks. So when I’m looking at a portfolio of preferreds, what would be my exposure to regional banks typically?

Rohan: Yeah, it’s a good question. Usually we do see that the financials universe makes up a big part of the issuers that offer preferred. So usually it’s somewhere around 70% of the issuance comes from financials. But when you actually break that down a little bit further, a lot of it is offered by some of these larger diversified banks out there. And then you have a smaller sliver in these regional banks, which have been, as you mentioned, getting a little bit more of the headline risk lately, which investors have been cautious about. So in our funds, for example, just using PFFD and some of the more investable universes out there, it’s only around like 5%, give or take.

So it’s a pretty small portion and not necessarily driving a lot of the way that the funds moves are going on a day-to-day basis. So it certainly is something to evaluate, especially in the context of potential contagion risk, but the overall exposure is lower. In fact, insurance companies make up around 15% maybe, give or take. So it’s usually a little bit higher of some of these other types of financials companies as opposed to the regional banks themselves.

Stewart: Very interesting. So final question. You have your choice. I’ve been doing the choice questions lately. Here we go. Best piece of advice you ever got? Or who would you most like to have lunch with, alive or dead? You can take either. You can take both.

Rohan: I’ll do both.

Stewart: Oh, look at that. I love this. Adventure. It’s good.

Rohan: So best piece of advice I ever got. So work as hard as you possibly can, more of something in the workplace, but I think even something you can carry forward into your personal life as well. Just because it was one of the first pieces of advice I actually got in that internship that I had at Merrill Lynch as my first job. And if you turn out to be a sponge for information, a lot of times that really flattens your learning curve quite a bit and enables you to really grow a ton both professionally and even personally. And so it’s something I’ve tried to carry forward and impart on others who I’ve come into contact in their career paths as well. So that would be my biggest piece of advice. Who would I most like to have lunch with, was, I believe, the question?

Stewart: Yeah, alive or dead?

Rohan: Alive or dead. So this individual is alive. Derek Jeter. I’m a very big-

Stewart: Oh, there you go.

Rohan: … Yankees fan. And so I really want to get the down low on what his thoughts were of some of those Yankees teams that he was on, both the ones that were completely dominant, some of the ones that were very newly constructed, like the one with Alex Rodriguez. And also on that topic, what he really thought of the relationship with Alex Rodriguez. A lot of internal speculation was going on, and so as a huge Yankees fan, I want to get to know what the actual thoughts were around the situation over the 20 years or so, where we’ve seen Yankees teams come and go.

Stewart: Very cool. That’s great. I really appreciate it. I’ve learned a lot today about preferreds, and I appreciate the education. So thanks for taking the time, Rohan. We appreciate you being on.

Rohan: Anytime. Thanks, Stewart.

Stewart: It’s been a pleasure to have you on. We’ve been joined by Rohan Reddy, director of research at Global X ETFs. Thanks for listening. Please like us, review us, and rate us on Apple Podcast. We certainly appreciate it. My name’s Stewart Foley, and this is the InsuranceAUM podcast.