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I’ve spent a lot of time over the past few months talking about the fixed income space.

• JAAA vs. Treasury Bills

• 5% Target Yield Model Portfolio

• 6% Target Yield Model Portfolio

My primary focus has been on the short-term and ultra short-term end of the spectrum. This is simply because I think they continue to offer the best risk/reward opportunities.

If you look up and down the list of fixed income options, including at their yield, duration and credit profile, there are certainly ETFs that offer a better yield than T-bills, but the risks can quickly outweigh any yield advantage.

The Treasury yield curve has finally normalized again, but it’s still mostly flat. You may or may not achieve a bigger total return depending on where rates go, but strictly in terms of yield vs. risk, T-bills offer the best option. The Janus Henderson AAA CLO ETF (JAAA) may be even better at the moment. It’s offering a 140 basis point yield premium to the iShares 0-3 Month Treasury Bill ETF (SGOV) with minimal additional risk.

The corporate credit market can get you anywhere from an 80 to 280 basis point yield premium, but how much credit and duration risk do you feel like taking? I’ve made my argument about why junk bonds are one of the worst risk/return trade-offs going right now. Short-term investment grade corporates aren’t too bad, but even those could get hairy too if the market starts to turn south.

That’s where preferreds, the stock/bond hybrid security, become an interesting option. With this category, you’ll get about a 180 basis point yield premium over T-bills right now, but they obviously come with much more risk given they’re closer to traditional common stocks than anything else on the list above.

Preferreds vs. Traditional Fixed Income

Preferreds fall between bonds and common stocks in a company’s capital stack. In the event of a liquidation, bondholders would be paid back first followed by preferred holders with whatever is left and then common stockholders at the tail end.

Preferreds are much more stable than common stocks and usually offer higher yields. Compared to bonds, however, they’re usually riskier and may come with lower credit ratings than traditional bonds because they get paid later.

The iShares Preferred & Income Securities (PFF), the largest in this space, has its portfolio primarily in three distinct credit buckets - about half in BBB-rated securities, 20% in BB-rated securities and 20% in unrated (with the remainder getting smattered around elsewhere).

From a pure diversification perspective, that makes preferreds and the ultra short-term bond ETFs listed earlier a fairly good match because of their much different duration and credit risk profiles. From a risk perspective, PFF rates closer to an intermediate- to long-term investment-grade corporate bond fund, even more than junk bonds.

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Let’s put PFF along side some other iShares fixed income ETFs to see how it profiles.

These numbers are looking at the last 10 years, so it covers the junk bond crisis of 2015-16, the COVID pandemic and the 2022 stock/bond bear market.

Preferreds actually rate as the second-worst category in this lineup for risk-adjusted returns. Obviously, T-bills and floating rate notes rate the best by a long shot because they were largely immune from the Fed’s aggressive rate hiking cycle post-pandemic. Rising rates clearly impacted preferreds to a degree, leaving them far behind short-term bonds, which avoided a good chunk of that interest rate risk, and junk bonds, which have remained in favor throughout the post-pandemic years.

Overall, returns over the past decade haven’t been that bad. While there’s been volatility along the way, they’ve lagged junk bonds, but outperformed everything else.

This feels like what we can generally expect out of preferreds over the longer-term in terms of absolute returns. A few bull periods, a few bear periods and returns that should outdo short-term fixed income over time.

How well they perform relative to riskier asset classes is very period-dependent. I would have thought that junk bonds would have performed worse in 2022, but bond market losses were mostly duration-driven. The U.S. economy largely did well and avoided recession, which allowed junk bonds to avoid most credit-related losses.

How well do preferreds fit into a broader fixed income portfolio? Probably fairly well, but it depends on what you’re mixing it with.

The non-existent correlation to T-bills obviously provides the biggest diversification benefits since they behave very differently.

Preferreds correlate pretty strongly with junk bonds, although they have a relatively strong correlation with all corporate bond maturities. If your fixed income portfolio is already heavier in long-term corporate bonds, the addition of preferreds may not do a lot to alter the overall risk/return profile.

Treasuries, however, are a different story. Longer-term T-notes and T-bonds have a relatively low correlation to preferreds and could smooth out the overall risk profile when combined. Volatility will be higher with long bonds, but yield will likely be higher with preferreds, making for a potentially more idea middle ground when they're paired.

Preferred ETF Rankings

I used PFF in the example above, but it currently comes in at #2 in my ETF rankings. It’s only topped by the Global X U.S. Preferred ETF (PFFD).

PFFD is clearly the cheapest of the group and clearly gives it a big advantage. At $2.3 billion in assets, there’s enough liquidity to keep trading costs low as well. Its monthly distribution schedule is also nice. The fund’s index is pretty broadly exposed, so this would make for a nice core holding if you’re considering adding preferreds.

Final Thoughts

Preferreds are different enough that they tend to mesh well with other traditional fixed, although the attractiveness of fit will depend on what you’re pairing it with.

Pairing with T-bills is essentially pairing it with cash, so it’s not very exciting, but it does reduce risk.

Pairing it with corporate bonds is less ideal because the correlations tend to be higher, especially with longer durations.

Pairing it with Treasuries provides the best combination of risk diversification and risk-adjusted return maximization. Plus, the fact that Treasuries are likely to behave as a safe haven asset during bearish periods should offset another level of downside risk.