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Why preferred securities should remain resilient in the face of COVID-19
- Banks are the largest sector within the preferred universe, and their fundamentals are stronger than in the past. The ability of U.S. banks to pass the Federal Reserve’s rigorous stress tests demonstrates the strength of their balance sheets.
- While regulators in Europe canceled their 2020 stress tests, surveys showed that European banks were better capitalized heading into the coronavirus pandemic than they were prior to the 2008-09 global financial crisis.
- Although preferreds may experience further volatility in the second half of the year, we think investors should focus on the fundamental strength of the banking sector and ride out these potentially turbulent-times.
Because banks are the largest sector within the preferred securities market, their fundamental health is a primary factor supporting the broader asset class. In this analysis, informed by the results of the Federal Reserve’s 2020 bank stress tests, we assess the state of bank liquidity and capital strength, explain why we think banks will continue to demonstrate resilience and make the case for including preferred securities in a diversified portfolio.
Preferred market compositionAs shown in Figure 1, financial institutions, banks in particular, make up most of the preferred universe. Since 2008, banks and brokerage firms (domestic and international) have issued large amounts of preferred securities to replenish capital depleted by housing and subprime losses suffered during the financial crisis.
U.S. banks are different todayBecause banks constitute almost half of the preferred securities universe, their stability is critical to the sector’s outlook. While some current market conditions remind us of the 2008 financial crisis period, the environment for U.S. banks today is meaningfully different. Banks have improved their ability to weather financial storms by:
- Maintaining higher liquidity levels. As of June 2020, reserve balances with the Federal Reserve totaled $2.9 trillion and banks had excess reserves (reserves that exceed the reserve balance requirement) of $2.9 trillion. At the start of 2007, U.S. banks only had reserve balances of $12 billion and $9 billion of excess reserves.1
- Owning more securities on their balance sheets. As of June 2020, banks owned $4.2 trillion in securities vs. $2.0 trillion at the start of 2007.2 In addition, these securities are higher quality and more liquid today, given the introduction of high quality liquid asset ratio requirements from Basel III.
- Improving their capitalization. Bank balance sheets are significantly better capitalized: The common equity tier 1 (CET1) capital ratio compares the bank’s risk-weighted assets to its tier 1 common equity, which includes ordinary shares and retained earnings. This ratio for all FDIC-insured banks was 13.0% at the end of 2019, versus 8.1% at the end of 2006.3
- Demonstrating the ability to pass rigorous regulatory stress tests. These tests were explicitly designed to simulate the performance of banks during periods of severe economic stress, such as the one we are currently experiencing.
The key role of bank stress tests
Why do we have bank stress tests?In the wake of the 2008 financial crisis, Congress passed the Dodd-Frank Act. One of the provisions of the Dodd-Frank Act requires the Federal Reserve to conduct an annual supervisory stress test. The stress tests apply three sets of macroeconomic scenarios — baseline, adverse and severely adverse — and project the impact on balance sheets, net income, capital levels and capital ratios. The stress tests are meant to provide bank management, regulators and other stakeholders forward-looking information to assess the potential effect of detrimental conditions on banks’ abilities to absorb losses while meeting credit obligations and continuing to lend.
The Federal Reserve has been conducting Dodd-Frank Act Stress Tests (DFAST) since 2013. As it turns out, though, the DFAST assumptions — although more severe than the conditions banks actually experienced during the 2008-09 global financial crisis — were not pessimistic enough to incorporate the economic fallout from the COVID-19 pandemic.
Consequently, the Fed expanded the stress tests to include sensitivity analyses under three coronavirus-driven downside scenarios, as shown in Figure 2: a V-shaped recession and rapid recovery; a slower, U-shaped contraction and rebound; and a W-shaped, double-dip recession. The Fed has cautioned that none of these scenarios should be considered forecasts.
What did the 2020 result show?In June 2020, the Fed released the results of its latest stress tests, which examined the financial health of 33 banks, each with at least $100 billion in assets.
Banks demonstrated resilience based on DFAST criteria. For the fifth straight year, all banks passed the DFAST scenario. As shown in Figure 3, the Fed projected that the banks, in aggregate, would achieve a CET1 ratio of 9.9% — more than twice the minimum 4.5% needed to continue their operations. Even banks in the lowest quartile were expected to maintain a level of capital sufficient to extend credit to individuals and businesses in a period of economic distress worse than the global financial crisis.
Outcomes were also positive under the three new sensitivity analyses. Banks appear to be well capitalized enough to sustain a base minimum CET1 ratio of 4.8%, even under the W-shaped, double-dip recession. Their performance prompted Fed Vice Chair for Supervision Randal Quarles to conclude that “the banking system remains well capitalized under even the harshest of these downside scenarios, which are very harsh indeed.”
The resilience of bank CET1, and in turn bank balance sheets, is not surprising given the strides banks have made since the financial crisis. Going into that crisis, banks’ CET1 ratio hovered around 7%-8%.4 However, since the crisis, banks have shored up their CET1, as shown in Figure 4. Ratios have steadily risen to a high of 13.01% at the end of 2019.4
Beyond the test resultsAlthough the Fed determined that the banks subjected to the stress tests “are sufficiently capitalized,” it also decided to take steps to help banks preserve capital. To that end, the Fed:
- Capped third-quarter dividend payments at the amount paid in the second quarter.
- Limited future dividend payouts to an amount equal to the average of each firm’s net income for the four preceding calendar quarters.
- Suspended stock buybacks. This was no surprise considering banks had already voluntarily stopped buybacks earlier this year and were not expected to resume them in 2020.
What about European banks?The European Banking Authority (EBA), which runs stress tests on European banks every two years, postponed its scheduled 2020 assessments until 2021. (According to the EBA, doing so will “alleviate the immediate operational burden for banks at this challenging juncture.”)
Although the stress tests have been delayed, in early June the EBA published the results of the first of two 2020 transparency exercises, with the second slated for late-fall release. Results of these exercises showed that the 127 banks examined across 27 European countries entered the COVID-19 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.
What do the results mean for preferred investors?We think both U.S. and European banks are currently better capitalized and more able to withstand a severe economic shock than at any point in history. Their larger capital cushions create a bigger buffer for preferred investors. On the balance sheet, preferreds sit between common equity and unsecured debt, so the more capital banks hold, the greater the safeguard for owners of preferreds.
It’s difficult to forecast how the economy will perform in the face of ongoing COVID-19 uncertainty. But strong overall responses to the Fed’s expanded stress tests show that banks can withstand historically challenging times, providing some confidence to investors. And suspending share buybacks and limiting dividend payments will boost levels of loss-absorbing common equity capital on banks’ balance sheets, offering added protection for preferred shareholders.
Why consider preferreds now?The preferred sector has gone through prior periods of distress, most notably during the 2008-09 financial crisis, when preferreds declined 25.2% (see Figure 5), and in the first quarter of 2020, when they fell 11.5%, according to the ICE BofA U.S. All Capital Securities Index. Most recently, in the second quarter of 2020, preferreds gained 10%, as investor demand returned amid unprecedented Federal Reserve market support.
While past performance is no guarantee of future results, we feel historical returns show investors have been rewarded for being patient and staying invested during times of stress.
Moreover, we believe there’s a strong case for continuing to include preferred securities in a well-diversified portfolio, based on many factors:
- Strong fundamentals. The solid underlying credit story of the preferred asset class is still intact, especially in the banking sector.
- Compelling valuations. Even after the second-quarter rally, preferreds remain attractively priced, with spreads 180 basis points wider than they were at the end of 2019.
- Attractive income. With the 10-year U.S. Treasury yield near a record-low 0.54%, and investment-grade corporates delivering just 2.15%, income-seeking investors may be drawn to the 4.32% payout offered by preferreds. (All data as of 30 June 2020. Investment grade corporate yield is based on the Bloomberg Barclays U.S. Aggregate Corporate Index; preferred yield based on the ICE BofA U.S. All Capital Securities Index. You cannot invest directly in indexes.)
- Low 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 remain secure.
ConclusionIn closing, we acknowledge that the periods of distress and volatility in the preferred securities market during the first half of 2020 have been challenging for investors. However, in our view, the continued healthy fundamentals of the banking sector— as well as compelling valuation, income and relative risk considerations for the asset class as a whole — make a strong case for maintaining a portfolio allocation to preferreds over the long term.
1 Federal Reserve
2 Federal Reserve
3 FDIC, NY Fed, Barclays Research
4 Dodd-Frank Act Stress Test 2019 results
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 fromsources 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.
The ICE BofA U.S. All Capital Securities Index is a subset of the ICE BofA U.S. Corporate Index including all fixed-to-floating rate, perpetual callable and capital securities.
A word on risk
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 issuermay 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.
Nuveen, LLC provides investment advisory services through its investment specialists.
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