Why Income Investors Should Consider Convertible Bonds and Preferred ETFs

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Income-oriented investors should consider the benefits of preferred securities and convertible bond exchange-traded fund strategies to increase their after-tax income.

During the recent webcast, Diversify Your Income Sources: Portfolio Building’s Best-Kept SecretSandra Testani, vice president of ETF products and strategy at American Century Investments, explained the benefits of preferred stocks, which are hybrid investments that share the characteristics of stocks and bonds and offer the potential for high current income. , superior credit quality, diversification benefits, and lower interest rate risk.

Testani argued that preferred stocks in a portfolio could offer enhanced returns without significantly sacrificing credit quality, provide diversification from traditional fixed income investments with less vulnerability to rising rates and, for tax-sensitive investors, offering an attractive after-tax return as income on preferred shares can be classified as eligible dividend income.

“In an era of scarce returns and growing tax challenges, preferred securities offer the opportunity to improve after-tax income and return potential, while providing diversification from other fixed-income investments,” Testani said. .

“Favorable tax treatment of qualified dividends can provide a higher after-tax return and benefit tax-sensitive investors,” she added.

Testani also pointed to the benefits of preferred stock diversification, as the correlation to traditional equities and fixed income securities can help improve yield and reduce volatility in a large portfolio. Preferred securities are generally high quality, issued by well capitalized companies in highly regulated industries such as banking, insurance, utilities and telecommunications – offering attractive yields comparable to lower rated bonds.

Additionally, Hitesh Patel, vice president and portfolio manager at American Century Investments, argued that with exposure to sectors likely to benefit from rising rates, a diversified portfolio of preferred securities can help reduce risk. interest rate. ​A diversified portfolio of preferred securities has historically proven resilient in past rising rate environments.​

As a way to tap into this market, Patel pointed to active management American Century Quality Preferred ETFs (QPFF).

The American Century Quality Preferreds ETF emphasizes quality that overweights issuers expected to deliver more sustainable dividends through the market cycle, uses sector valuations to address significant benchmark bank exposure, and monitors credit risk , liquidity, rates and structural to mitigate acute risks. the price goes down.

The QPFF attempts to identify high-quality issuers by eliminating issuers most likely to suspend dividends in difficult market environments and focusing on earnings quality and market capitalization. Fund managers also use sector filters to further refine the investment universe to account for idiosyncrasies between banking and non-banking sectors and to optimize the remaining issuers based on valuation and yield. The strategy seeks securities with the best structural characteristics, taking into account market inefficiencies that may affect the relative valuation of issues. Finally, the ETF ensures alignment with the overall portfolio risk/return objectives, liquidity and portfolio constraints.

The desired outcome is a preferred portfolio with higher quality, more profitable issuers that can sustain dividends through the market cycle, lower exposure to cyclical sectors, larger market capitalization, and attractive portfolio yield without sacrificing significantly the credit quality.

“Our process addresses some of the shortcomings of the broad index-based passive approach which ignores fundamental issuer risks and structural complexities specific to that asset class and is unable to alter the security mix and risk exposure. depending on changing market conditions,” Patel said.

“Our quantitative and fundamental process identifies quality issuers with low credit risk, low leverage and strong stable earnings with high profitability with the ability to maintain stable dividends over multiple economic cycles.”

Testani also pointed to the benefits of convertibles, fixed-income securities with a built-in option to convert to equity. These assets offer the potential for attractive risk-adjusted returns, upside potential with limited downside capture, low interest rate sensitivity and a yield advantage over growth stocks.

Testani argued that convertibles in a portfolio offer exposure to growth stocks with higher yield and lower downside risk, and offer diversification compared to traditional fixed income investments, with less vulnerability to rising interest rates. Convertibles tend to be issued by cyclical growth-oriented companies. Many issues are not rated and, due to call features, may have very short durations.

For exposure to convertible bonds, the American Century Quality Convertible ETF (QCON) is an actively managed convertible bond portfolio that emphasizes quality, sector diversification and a balance between beta exposure to optimize risk/return potential for investors looking for an alternative strategy of diversification.

“Investors have traditionally held convertibles through low-cost passive portfolios designed to mimic a broad benchmark or expensive actively managed mutual funds. We believe that broad index-based passive products that are spread across the US convert universe based on the market weight of the underlying issue in the market are independent of the risks and structural complexities specific to that class. of assets, which can lead to unintended results. The passive structure contains inherent flaws. They ignore fundamental issuer risks and are unable to change the mix of securities and risk exposure based on changing market conditions,” Patel said.

The American Century Quality Convertible Securities ETF is overweight issuers with stronger earnings profiles, stronger balance sheets and above-average credit ratings. It also aims for a more balanced beta range for the portfolio to mitigate sharp price declines, and aims to diversify across industries and sectors to deal with benchmark concentration.

QCON’s bond-like convertible bond segment weeds out issuers with the highest risk of default and optimizes issuers based on their valuation and yield. The convertible equity portion of the ETF eliminates issuers with the lowest profitability and lowest realized growth, instead optimizing issuers for profitability and growth. The portfolio then seeks out securities with the best structural characteristics, taking into account market inefficiencies that may affect the relative valuation of issues. Finally, it ensures alignment with overall portfolio risk/return objectives, liquidity and portfolio constraints.

The desired outcome is a portfolio of convertible bonds with higher quality issuers, lower exposure to cyclical sectors, and lower exposure to securities with the highest and lowest betas.

Financial advisors interested in learning more about Income Strategies can watch the webcast here on demand.

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