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Preferred securities in institutional portfolios
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. Institutional investors often overlook this hybrid asset class, but we find the fundamentals especially attractive. Market inefficiencies may also provide opportunities to add alpha to fixed income portfolios.
Traditionally known as a retail market segment, we think preferred securities offer many benefits for institutional portfolios, including:
- Predominantly investment grade securities that may offer more yield potential
- Inherent market structure inefficiencies create alpha opportunities for active managers
- Lower correlation to other fixed income and equity asset classes
- Reduced interest rate sensitivity through careful security selection
- Strong fundamentals of the bank sector, the largest segment of the preferred universe
Together, these attributes may make preferred securities attractive for institutional investment grade fixed income portfolios seeking to add yield and total return potential, along with the diversification benefits of a lower correlated asset class.
Structure and history
Preferred securities don’t fit neatly into an asset allocation category, as they contain features of both equity and debt instruments. A preferred security can be classified as either a bond or a stock on the balance sheet, depending on its features. The easiest way to identify preferred securities is by their placement within the corporate capital structure.
A preferred security can be classified as either debt or equity on the balance sheet.
Figure 1 illustrates how they 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. Financial institutions now make up the lion’s share of the 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 Figure 3.
Preferred securities are generally issued by high quality companies. Due to their subordinate capital structure position, individual preferred securities 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 senior 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) bonds.
Figure 4 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 of companies issuing preferred securities are A rated.
Market inefficiencies may create alpha opportunities
In addition to the various structures detailed in Figure 3, the more than $500 billion U.S. preferred securities market is primarily composed of two types of issues:4
- $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.
Figure 5 is a historical example that 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 extreme differences in valuations between two securities. In this historical 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 differences in pricing between the retail and institutional markets.
In 2018, for example, four fairly large preferred deals that were all trading at negative yields to call were called. This resulted in substantial investor losses, as shown in Figure 6. 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.
Access to the international market
Securities issued by non-U.S. entities in U.S. dollars constitute 48% of the U.S. dollar denominated market.5 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.
Lower correlation to traditional asset classes
Since preferred securities include features of both bonds and stocks, the asset class exhibits relatively low correlation to both equity and fixed income asset classes, as shown in Figure 7. Adding an allocation of preferred securities to a portfolio may improve overall portfolio construction.
Adding income to portfolios
In today’s environment, the attractive yield of preferred securities often piques investor interest first. Since preferreds are lower in the capital structure and thus carry more subordination risk, they generally feature wider credit spreads and pay a higher level of income than their senior debt counterparts.
Preferred yields are attractive in an absolute sense and compelling compared to the broader investment grade bond universe, as shown in Figure 8. They are also attractive relative to high yield bonds and emerging market debt on a risk-adjusted basis.
Less sensitivity to rising interest rates
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.
Several features of the preferred universe help active managers dampen the impact of changing interest rates on portfolios.
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 66% of the issuer base.5 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.
Solid outlook for preferreds
Because banks are the largest sector in the preferred universe, their stability is critical to the outlook. Some current market conditions remind us of the 2008 financial crisis period, but today’s environment for U.S. banks is meaningfully different. Banks now have significantly higher capital levels and greater liquidity. They have passed rigorous regulatory stress tests and own more high quality securities.
All U.S. banks subject to the Dodd-Frank Annual Stress Tests (DFAST) passed not only the regularly prescribed stress test, but also three additional sensitivity analyses constructed to reflect current conditions associated with the coronavirus pandemic. Although the DFAST assumptions were already more severe than the conditions banks actually experienced during the global financial crisis, they were not pessimistic enough to incorporate the economic fallout from the coronavirus pandemic.
Consequently, the Federal Reserve (Fed) expanded the stress tests to include sensitivity analyses under three coronavirus-driven downside scenarios: a V-shaped recession and rapid recovery; a slower, U-shaped contraction and rebound; and a W-shaped, double-dip recession. All U.S. banks passed the additional scenarios, confirming the resiliency of their balance sheets.6
European and U.K. banks also endure regular stress tests. Although the European stress tests have been delayed, in early June the European Banking Authority (EBA) published the results of the first of two 2020 transparency exercises, with the second slated for late-fall release. Results showed that the 127 banks examined across 27 European countries entered the coronavirus crisis with solid capital positions and improved asset quality. In particular, the EBA confirmed that these institutions held larger capital and liquidity buffers than they did heading into the 2008-09 financial crisis.
Despite the stress test results, regulators took additional precautionary measures to protect the global banking system. The Fed mandated that all banks suspend share buybacks until at least the third quarter, and limited the amount of common dividends that banks may pay to common shareholders. These measures will help to retain extra common equity capital on U.S. bank balance sheets until regulators feel more comfortable about the direction of the domestic and global economies.
In Europe, the Bank of England (BOE) and European Central Bank (ECB) mandated that banks under their purview suspend both share buybacks and common dividends, to conserve capital and boost levels of loss-absorbing common equity capital on banks’ balance sheets.
We do not believe these regulatory actions have put preferred and/or contingent capital security distributions at risk. First, as long as an issuer of a preferred security is paying any common dividend, it must pay distributions on its preferred securities. In the U.S., a handful of banks may trim their common dividend distributions in light of recent Fed guidelines, but we do not expect any banks subject to this year’s stress tests to fully suspend their common dividend distributions.
Second, and in the case of the European bank sector where both share buybacks and common dividends have been fully suspended, both the ECB and the BOE have explicitly stated that AT1 and T2 distributions were not part of the mandate. Further, we believe that if the Fed ever forced U.S. banks to suspend common dividends, it likely would take an approach similar to the ECB and BOE and explicitly state that the suspension of capital distributions was specific to common dividends.
Unlike 2007, global central banks, regulators and governments have willingly supported the bank sector, both directly and indirectly. Regulators have provided meaningful capital relief for banks, freeing up additional balance sheet capacity across the bank sector, allowing banks to provide additional credit and liquidity to the global economy. In addition, Fed and ECB bond buying programs have led to explosive growth in the new issue market for investment grade corporate bonds, sparking a meaningful uptick in underwriting and trading revenue for banks. More importantly, it also alleviated the burden on banks to be the primary provider of credit and liquidity to corporate America.
In summary, we feel both U.S. and European banks are significantly better capitalized and more able to withstand a severe economic shock than at any point in history. The larger common equity capital cushions create a protective buffer for preferred investors. On the balance sheet, preferreds sit above common equity. The more common equity capital banks hold, the greater the safeguard for preferred security investors.
It’s difficult to forecast how the economy will perform in the face of ongoing coronavirus uncertainty. But strong overall results to the Fed’s expanded stress tests show that banks can withstand conditions worse than what we have witnessed in the modern era, which should provide confidence to investors.
Why consider preferreds now?
Besides the solid fundamentals of the bank sector, there are other reasons to consider preferred securities for portfolio today, including:
More compelling valuations. While spreads will likely remain volatile pending further clarity around the coronavirus crisis, we believe risk premiums look relatively attractive. Spreads are wider than they were at the end of 2019 across all segments of the preferred market, creating a more attractive entry point. The valuation changes are most pronounced in the $25 par market. Retail investors and ETFs focused on $25 par value securities sold significant holdings, resulting in significantly wider spreads.
Attractive income. With the 10-year U.S. Treasury yield and investment grade corporate bond yields near record-lows and little prospect of rising rates on the horizon as the Fed is on hold, the additional income provided by preferred securities becomes more attractive.
Lower likelihood of impairment. While similar-yielding high-yield bonds and leveraged loans are expected to experience marginally higher default rates, we think preferred security distributions can remain secure, especially in the bank and insurance industries. See how these industries have very low forecast default rates in both the U.S. and Europe over the next year relative to the broader credit market.
Preferred securities may become more common
While preferred securities are not widely employed by institutional investors, we think their features will likely make them more common in the future. As a predominately investment grade asset class with more yield potential, preferreds may help boost portfolio returns while improving overall efficiency through their low correlation to other assets classes. Interest rate sensitivity can be reduced by managing security structure, and the market presents ample alpha opportunities for active managers. We believe preferred securities are currently attractive based on the fundamental strength of the bank sector and other factors.
1 Floating rate securities are bonds whose coupon rates adjust periodically based on a specified reset mechanism. Floating rate securities include most bank loans and some preferred stock.
2 Inverse floating rate securities refers to a type of security with income that may vary inversely to the rate of a specified underlying bond held in a tender option bond trust.
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.
A word on risk
Past performance is no guarantee of future results. Prospective clients should review their investment objectives, risk tolerance, tax liability and liquidity needs before choosing a suitable investment style or manager. There are risks inherent in any investment, including the possible loss of principal. There can be no assurance that fund objectives will be achieved. Closed-end funds frequently trade at a discount to their net asset value.
This report is for informational purposes only and is not intended to predict or depict performance of any investment. The statements contained herein are based upon the opinions of Nuveen, LLC, and the data available at the time of publication of this report, and there is no assurance that any predicted results will actually occur.
Nuveen Securities, LLC, Member FINRA and SIPC.