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Fixed income perspective: preferred securities
Preferred securities can offer higher income potential compared to other fixed income sectors. Primarily investment grade securities, their low correlation to other fixed income sectors and equities may also strengthen portfolio construction in an uncertain environment. We find preferred securities attractive today from fundamental, technical and valuation perspectives. Market inefficiencies may also provide opportunities to add alpha to fixed income portfolios, and certain structures may have tax advantages.
In today’s environment of continued low interest rates and rising volatility, preferred securities appear attractive for their historically high relative yields and their ability to weather changing interest rate environments. They also may help diversify a fixed income portfolio due to their historically low correlation to other bond and stock asset classes. We believe preferred securities offer many additional benefits, including:
- Tax-advantaged income potential, since many preferred security structures may pay qualified dividend income (QDI)
- Reduced interest rate sensitivity through fixed-to-floating rate coupon structures
- Predominantly investment grade securities to help manage credit risk
- Inherent market structure inefficiencies that may create alpha opportunities for active managers
- Historically strong fundamentals, improving technicals and attractive valuations for $1000 par securities
What is a preferred security?
Preferred securities don’t fit neatly into an asset allocation category, as they contain features of both stocks and bonds. A preferred security can be classified as either debt or equity on the balance sheet, depending on its features. The easiest way to identify preferred securities is by their placement within the corporate capital structure.
Exhibit 1 illustrates how preferreds typically reside on the boundary between debt and equity. In a bankruptcy or liquidation, preferred security owners have a higher priority than common stock owners, but a lower priority than senior debt holders. They will be paid only if there is money left after senior creditors have been made whole.
Preferred securities trace back to the 16th century in England and the 1850s in the United States. However, in the 1980s they evolved from a financing tool for highly regulated utilities to an important financing vehicle for financial institutions.1 Since then, the preferred securities market has experienced significant growth and a change in issuer composition.
A preferred security can be classified as either debt or equity on the balance sheet.
Financial institutions now make up most of the preferred universe. Since 2008, banks and brokerage firms (domestic and international) have issued preferreds en masse to replenish capital depleted by housing and subprime losses during the financial crisis.
Types of preferred securities
A preferred security’s combination of features will classify it as either an equity or a fixed income security, but most preferred securities have elements of each. For example, some preferred securities generate income in the form of interest, while others generate income in the form of dividends. Other common features are shown in Exhibit 3.
Potential benefits of preferred securities
Preferred securities potentially offer relatively attractive yields, especially in today’s lower rate environment. They may also provide less sensitivity to interest rate changes, portfolio diversification and tax-advantaged income. This combination has created significant interest in the asset class.
Attractive relative yields
Because they are lower in the capital structure and thus carry more subordination risk, preferred securities generally contain wider credit spreads and pay a higher level of income than their more senior debt counterparts. As shown in Exhibit 4, preferred securities have had attractive yields relative to other asset classes. They have offered more income-generating power than equities and most fixed income asset classes, with the exception of high yield bonds.
Tax-advantaged income potential
Beyond an attractive yield, a majority of preferred securities pay qualified dividend income (QDI), which may enhance after-tax yield. Since preferred securities are hybrids of stocks and bonds, certain preferred securities generate qualified dividend income. This type of income is typically created by common stocks and taxed at the lower capital gains tax rate. In contrast, traditional fixed income investments create income subject to ordinary income tax rates.
A high quality investment
Preferred securities are generally issued by high quality companies. Due to their subordinate capital structure position, preferreds may be rated 3 to 5 quality notches lower than the senior debt of the same issuer. For instance, an entity issuing a preferred security rated BB would typically have investment grade senior unsecured debt rated BBB or higher. Although preferred securities are lower in the capital structure than traditional bonds, many are investment grade in nature. They may produce a higher yield than investment grade corporate bonds without the credit risk of a below-investment-grade, high yield bond.
Exhibit 5 shows how the quality of the company issuing the preferred securities is typically much higher than the rating of the individual securities. For example, most individual preferred securities are rated BBB, but most companies issuing preferred securities are A rated.
Since preferred securities include features of both bonds and stocks, it is not surprising that the asset class exhibits relatively low correlation to both traditional fixed income and equity categories, as shown in Exhibit 6. This means that adding a slice of preferred securities to a portfolio may improve overall portfolio diversification.
Less sensitivity to interest rate changes
While rates have recently moved lower, managing interest rate risk remains critical for fixed income portfolios. When interest rates are low and remain low for long periods of time, the bigger risk to portfolios can be sudden unexpected increases in rates. Indeed, when interest rates go up, bond prices go down, but different types of bonds have varying sensitivities to changes in interest rates.
Since most preferreds have longer-dated maturities (many are perpetual), it may seem counterintuitive for them to perform in a rising rate environment. Longer-maturity securities are generally more sensitive to rising rates. As active managers, several features of the preferred universe help us dampen the impact of changing interest rates on our portfolios.
- Higher coupon rates. The higher average coupon rate of preferred securities can make them less sensitive to changes in interest rates because the income of the bond remains constant as rates change, reducing the impact.
- Credit spread sensitivity. Due to their lower position in the capital structure, preferred securities are often more sensitive to changes in credit spreads than other types of bonds. On a relative basis, they may perform well during periods of gradually increasing interest rates, as credit spreads often tighten during periods of rising rates.
- Different available coupon structures. Preferred securities are issued with a number of different coupon structures that active managers can use to help adjust the portfolio for changing rate environments.
- Fixed rate coupons generally pay a specified coupon rate for life. These structures can be beneficial when rates are expected to decline, as the coupon will remain more valuable and provide constant income during low rate periods.
- Fixed-to-floating rate coupons often contain the following features, which make them less sensitive to rising rates:
- Pay a fixed coupon for a preset number of years (commonly 5 or 10), then convert to a floating rate coupon for the remaining life of the security or until it is called (known as fixed-to-floating rate coupons).
- The floating rate coupon is based on a benchmark rate, such as 3-month LIBOR, plus a predetermined spread set when the security is issued.
Compared to fixed-rate coupon structures, fixed-to-floating rate coupon structures typically experience less duration extension when rates rise. This feature makes them less sensitive to rate changes in a rising rate environment. They usually experience better relative price performance, since the prices of lower duration bonds are less affected by rising rates. Lastly, the floating rate nature of the coupon allows the securities to capture increases in interest rates, because the coupon should increase with interest rates.
Industry composition. Banks represent about 67% of the issuer base.4 In a rising rate environment, we think the banking sector will benefit, as bank profit margins will likely improve as interest rates rise, and banks can earn more on loans and investments. A higher interest rate environment generally means the economy is improving, which can result in a higher demand for loans and a decreasing percentage of nonperforming loans. In a declining rate environment where bank profits are squeezed, active managers can rotate into other industries with less rate sensitivity.
Market inefficiencies may create alpha opportunities
In addition to the various structures detailed in Exhibit 3, the more than $500 billion U.S. preferred securities market is primarily composed of two types of issues:5
- $25 par value securities that trade on the major stock exchanges and target retail investors.
- $1000 par value securities that trade over the counter and target institutional investors.
These distinct market segments offer opportunities for a professional asset manager to add alpha by managing portfolios between these denominations.
Mispricing between issues
Two preferred markets means pricing discrepancies can and do often occur. For example, a company may issue both $25 and $1000 par value securities with the same credit and structural risk. A professional manager can compare the difference in economics for essentially the same security, selling what they believe to be the overpriced security and buying the underpriced security. In some cases, the difference in valuations between the two markets can be substantial.
Exhibit 8 shows two securities that were nearly identical: one $25 par and one $1000 par. Retail investors often focus on coupon rate when valuing securities, which can drive $25 par securities to relatively rich levels in their search for income. Institutional investors tend to value securities based on yield spreads to U.S. Treasuries or senior debt. The result can be an extreme difference in valuations between the two securities. In this example, an investor could have paid less for the institutional $1000 par securities and gained 43 basis points (bps) in yield versus the same structure in a $25 par.
Active management of scheduled call risk
Most of the preferred security universe has explicitly stated call provisions. Most preferred issuers will call securities when they can be refinanced at cheaper levels. This is usually in response to lower interest rates and/or tighter credit spreads, or when the issuer already has excess capital on its balance sheet. Scheduled calls of preferred securities trading at premiums may lead to investor loss, especially when investors are not actively managing yields to call.
Recently, valuations for retail $25 par preferred securities became so rich that a significant population of securities traded at negative yields- to-worst/yields-to-call. This illustrates some of the vast pricing differences between the retail and institutional markets.
In 2018, for example, four fairly large preferred deals were called, all trading at negative yields to call. This resulted in substantial investor losses, in Exhibit 9.
Managing call risk should be a high priority for preferred investors. A professional asset manager has the experience and resources to understand and position portfolios for these extreme pricing scenarios.
Larger block sizes and greater liquidity
The institutional side of the market typically trades in larger block sizes, while the average retail investor typically does not have large enough positions to efficiently access this market.
Access to the international market
Securities issued by non-U.S. entities in U.S. dollars constitute approximately 49% of the U.S.-dollar-denominated market.6 This market tends to be dominated by institutional $1000 par value securities. Retail investors typically ignore this market, and research departments provide less coverage. Adding these securities to a portfolio may increase issuer diversification and reduce correlation with U.S. asset classes.
Solid outlook for preferreds
We believe the current market environment presents an opportunity for preferreds. From technical, fundamental and valuation perspectives, we find the asset class attractive.
Supply and demand are out of balance
Investors are buying preferreds, but supply remains constrained. This positive technical should support the asset class. The dramatic outflows of -$6 billion the preferred securities asset class experienced in the fourth quarter of 2018 have reversed. Preferreds have seen +$4.4 billion in inflows year to date through June 30.7 We think the asset class can recapture more of the 2018 outflows, as investor demand should remain strong given the higher yields of preferred securities in a lower rate environment.
U.S. banks proactively raised capital and reduced the size of balance sheets to meet the new capital requirements set forth by the Dodd-Frank Act and Basel III Accord. Banks effectively raised more capital, primarily through the growth of retained earnings and issuance of preferred securities. Today, U.S. banks hold almost the exact amount of preferred security exposure necessary to meet regulatory requirements. As a result, we expect net preferred security issuance to be flat in the near term.
Despite positive net new issue flow year to date, we expect that calendar year 2019 net new issue flow from the U.S. bank sector will be flat. We anticipate that redemption activity will outpace new issue flow between now and year-end. We believe that issuers have taken advantage of recent favorable market conditions to bring new issue preferred securities to refinance currently callable and near-term callable structures, as corroborated by use-of-proceeds disclosures on recent new issue deals. Given the composition of currently callable and near-term callable preferred securities, we also expect future redemption activity to be biased toward the $1000 par side of the market.
Fundamentals are strong
U.S. bank balance sheets are proving to be incredibly resilient. The results of this year’s Dodd-Frank Act and Comprehensive Capital Analysis and Review stress tests again underscored the strength of U.S. bank balance sheets, even under dire economic conditions. Recent EU and UK stress tests have shown similar results for large European names. For the first time ever in 2018, the Big 6 U.S. banks generated aggregate net income in excess of $100 billion over a calendar year. While we do not expect a repeat performance in 2019, we believe the backdrop for our largest sector is solid.
The banking sector also continues to operate under intense regulatory oversight and scrutiny. The banks’ post-crisis business model has been de-risked meaningfully with limits on proprietary trading, heavier regulation of the derivatives market and imposed guardrails to meet annual stress tests and capital review requirements. As a result, we think the credit risk of bank-issued preferreds is lower now than in the past. We believe the improvement in credit quality should translate into a lower risk premium (credit spread), resulting in capital appreciation for preferred securities.
$1000 par market remains more attractive
We continue to find the $1000 par market more attractive than $25 par preferreds. $1000 par securities continue to be significantly cheaper than the $25 par side of the market on a yield and spread basis. The yield-to-worst and average option-adjusted spread of $25 par securities was lower than that of $1000 par securities, as shown in Exhibit 11.
In addition to negative net supply, strong demand from retail investors and passive ETFs for $25 par value securities has created these pricing distortions. Investors have historically demonstrated a strong bias for income-generating investments, but cannot always appropriately value securities. They have often been purchasing the retail-sized denominations of $25 par preferred securities, based on their high coupon rates alone. As a result, they have driven up the prices of these securities and yields have declined.
In addition, most passive, preferred-security ETFs only purchase the $25 par value, exchanged-traded securities. As demand for income-generating ETFs has increased, the passive, preferred-security ETFs have also purchased large amounts of $25 par value securities, driving yields down as prices rise.
We also tend to prefer $1000 par securities because they contain a greater number of securities with coupon structures that have reset features. As illustrated in Exhibit 7, these structures reduce duration extension risk when rates rise.
Adding preferred securities to a portfolio
Exhibit 12 shows sample portfolios and their performance during different historical interest rate environments. Of course, individual investors should discuss personal circumstances with a professional advisor.
1 “Hybrid Capital,” J.P. Morgan, 14 Oct 2014.
2 Dividend Received Deduction allows corporations to deduct 70% of the income received from federal taxable income. Please consult a qualified tax advisor for details on your particular situation
3 Qualified Dividend Income is taxed at the capital gains rate.
4 Data source: Custom blend of 60% ICE BofA U.S. All Capital Securities Index and 40% ICE BofA Contingent Capital USD Hedged Index, as of 30 Jun 2020, Nuveen.
5 Data source: Nuveen, 31 Aug 2020. $50 and $100 par securities exist, but they are much less common.
6 Data source: Based on ICE BofA U.S. All Capital Securities Index and ICE USD Contingent Capital Index as of 30 Jun 2020, Nuveen.
7 Data source: https://www.federalreserve.gov/publications/files/2020-dfast-results-20200625.pdf.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Alpha is the excess returns of an investment relative to the return of a benchmark index.
A cumulative dividend is a right associated with certain preferred shares of a company. A fixed amount or a percentage of a share’s par value must be remitted periodically to shareholders who own these shares without regard to the company’s earnings or profitability.
Noncumulative describes a type of preferred stock that does not pay the stockholder any unpaid or omitted dividends. Preferred stock shares are issued with a stated dividend rate, which may be a stated dollar amount or a percentage of the par value. If the corporation chooses not to pay dividends in a given year, the investor does not have the right to claim any of the unpaid dividends in the future.
Standard deviation is a measure of the dispersion of a set of data from its mean. If the data points are farther from the mean, there is higher deviation within the data set. It is used to measure the volatility of an investment.
Yield is the income return on an investment, such as the interest or dividends received from holding a particular security.
Yield-to-worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.
Bloomberg Barclays Credit 1-3 Yr Index is a broad-based benchmark that measures the return of bonds with 1-3 year maturities.
Bloomberg Barclays 7-10 Year U.S. Treasury Index contains securities in the Treasury Index with a maturity from 7 up to (but not including) 10 years.
Bloomberg Barclays Global Aggregate ex-U.S. Hedged Index measures the performance of global bonds. It includes government, securitized and corporate sectors.
Bloomberg Barclays Municipal Bond Index covers the USD denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and prerefunded bonds.
Bloomberg Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities and asset-backed securities.
Bloomberg Barclays U.S. Intermediate Investment Grade Corporate Index is a broad-based benchmark that measures the intermediate investment grade, fixed-rate, taxable corporate bond market.
Bloomberg Barclays USD Capital Securities Index contains securities viewed as hybrid fixed income securities that either receive regulatory capital treatment or a degree of “equity credit” from the rating agencies. This generally includes Tier 2/Lower Tier 2 bonds, perpetual step-up debt, step-up preferred securities, and term preferred securities.
Bloomberg Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury. Treasury bills are excluded by the maturity constraint but are part of a separate Short Treasury Index. In addition, certain special issues, such as state and local government series bonds (SLGs), as well as U.S. Treasury TIPS, are excluded. STRIPS are excluded from the index because their inclusion would result in double-counting.
Bloomberg Barclays U.S. Corporate Index measures the market of USD-denominated, fixed-rate, taxable corporate bonds.
ICE BofA BB-B U.S. Cash Pay High Yield Constrained Index contains all securities in the U.S. High Yield Index rated BB+ through B- by S&P (or equivalent as rated by Moody’s or Fitch), but caps issuer exposure at 2%. Index constituents are capitalization-weighted, based on their current amount outstanding, provided the total allocation to an individual issuer does not exceed 2%.
ICE BofA Preferred Stock Fixed Rate Index is designed to replicate the total return of a diversified group of investment grade preferred securities.
ICE BofA U.S. All Capital Securities Index is a subset of the ICE BofA Merrill Lynch U.S. Corporate Index including all fixed-to-floating rate, perpetual callable and capital securities.
JPMorgan EMBI Global Diversified Index is an unmanaged, market-capitalization weighted, total-return index tracking the traded market for U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.
S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy.
A word on risk
This information represents the opinion of Nuveen and is not intended to be a forecast of future events and thus is no guarantee of any future result. It is not intended to provide specific advice and should not be considered investment advice of any kind. Information was obtained from third party sources that we believe to be reliable but are not guaranteed as to their accuracy or completeness. This report contains no recommendations to buy or sell specific securities or investment products. All investments carry a certain degree of risk, including possible loss of principal and there is no assurance that an investment will provide positive performance over any period of time. Investing in preferred securities entails certain risks, including preferred security risk, interest rate risk, income risk, credit risk, non-U.S. securities risk and concentration/nondiversification risk, among others.
There are special risks associated with investing in preferred securities, including generally an absence of voting rights with respect to the issuing company unless certain events occur. Also in certain circumstances, an issuer of preferred securities may redeem the securities prior to a specified date. As with call provisions, a redemption by the issuer may negatively impact the return of the security held by an account. In addition, preferred securities are subordinated to bonds and other debt instruments in a company’s capital structure and therefore will be subject to greater credit risk than those debt instruments. Credit risk is the risk that an issuer of a security will be unable to make dividend, interest and principal payments when due. Interest rate risk is the risk that interest rates will rise, causing fixed income securities prices to fall. Income risk is the risk that the income will decline because of falling market interest rates. This can result when an account invests the proceeds from new share sales, or from matured or called fixed income securities, at market interest rates that are below the account’s current earnings rate. An investment in foreign securities entails risks such as adverse economic, political, currency, social or regulatory developments in a country including government seizure of assets, lack of liquidity and differing legal or accounting standards (non-U.S. securities risk). Preferred security investments are generally invested in a high percentage of the securities of companies principally engaged in the financial services sector, which makes these investments more susceptible to adverse economic or regulatory occurrences affecting that sector concentration/nondiversification risk). It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
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