They’re Not All Just Bonds in Disguise.

There’s a good reason why this newsletter isn’t called Fixed Income Securities Investor. Unlike publications that focus on one particular type of income investment, ISI has always covered the waterfront. Consequently, a portfolio constructed from the newsletter’s recommendations doesn’t consist entirely of bonds, quasi-bonds, and bond surrogates, all rising or falling together with each lurch in interest rates. As the financial press reminds us almost daily, when interest rates go up, prices of fixed-rate bonds go down. It’s not so cut and dried for other income categories.

Unlike bond coupons, distributions on REITs, MLPs, and dividend growth stocks aren’t fixed. Instead, they have the ability to grow over time. Also, while a general increase in interest rates reduces the market value of fixed-rate bonds, it boosts present or future income on fixed-to-floating preferreds. The analysis presented in the accompanying chart quantifies the degree to which prices of various types of investments move together.

If the cell where two asset classes intersects contains a value of 1.00, it means they always move in lockstep. Combining those two kinds of securities provides no diversification benefit. On the other hand, a value of 0.00 means the two asset classes have no tendency to move together.

Monthly Price Correlation--June 2005 to December 2019
Sources: Bloomberg, ICE Indices, LLC
10-Yr. Treas  
Preferreds -0.16  
REITs -0.11 0.46  
MLPs -0.17 0.38 0.14  
Dividend Growth Stocks -0.10 0.05 0.86 -0.06

The asset categories depicted in the table are represented by the ICE BofAML US Treasury Index,
S&P Preferred Stock Index, the MSCI US REIT Index, the Alerian MLP Index, and the
S&P 500 Dividend Aristocrats Price Index. June 2005 is the earliest month in which numbers are
available for all asset categories.

Some market participants perceive preferreds as “stocks that act like bonds.” They will be surprised to learn that in the period covered by the table, the correlation between Treasury bonds and preferreds was actually less than zero (-0.16)! Here’s why: A strengthening econ-omy tends to boost interest rates. That hurts a Treasury bond, the price of which is purely interest-rate-driven. But an economic uptick helps a preferred stock by lowering the portion of its yield linked to the risk that the issuer won’t pay the dividend.

So, for example, in September 2019 Treasuries fell by 1.2% yet preferreds rose by 0.3%. It went the opposite way in the 2008-2009 Great Recession, as investors fled all risky investments for the safety of Treasuries. Since the recession ended in June 2009, the Treasury/preferred correlation has been close to zero (-0.03).

Even with a somewhat positive correlation, owning both bonds and preferreds spreads your risk more widely than holding a portfolio driven purely by interest rate fluctuations. The table tells similar stories about the other asset classes. Their price moves aren’t exclusively a function of interest rates. And unlike non-discounted bonds, they offer meaningful, long-run upside.