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Preferred Securities  Download PDF
March 31, 2008
We are pleased to share with you our review and outlook for the preferred securities market as of March 31, 2008. In the first quarter, the Merrill Lynch Fixed Rate Preferred Index had a total return of 5.5%.
Investment Review
After putting in their worst performance ever in 2007, preferred securities rebounded in January as investor confidence improved and tax-loss selling abated. The Federal Reserve’s substantial reduction in interest rates, Congress’s passing the economic stimulus plan and the emergence of Bank of America as a buyer for Countrywide Financial all boosted general investor sentiment.
While preferreds had positive returns for the quarter, they gave back some gains in February and into mid-March as investors retreated from equity and preferred securities alike amid ongoing credit concerns. In fact, the spreads of most credit products, including preferred securities, widened in March, fueled by the near-collapse of Bear Stearns and large-scale sell-offs of AAA-rated commercial mortgage-backed securities (CMBS). In addition, the supply pipeline of preferreds opened wide again in February and March as financial institutions seeking to recapitalize again tapped the market in record volumes. This new supply put pressure on prices of existing issues. This supply was largely constrained to financial issuers; issuance in other sectors, such as the REIT sector, was much more limited.
Investment Outlook
Preferred securities have a history of performing well in periods of declining interest rates, and additional rate cuts may be on the horizon. As it typically takes three quarters for easing interest rates and fiscal stimulus policies to evince results, we expect the actions the Fed started taking in the second half of 2007 to begin bearing fruit in the coming months. Fiscal stimulus measures may also have a salubrious effect.
We anticipate the actions the Federal Reserve and Congress have taken will help stabilize the markets in coming months; the Fed is now providing liquidity to all its primary dealers for the first time in history, and Congress has enabled the housing-related government-sponsored enterprises (Fannie Mae, Freddie Mac, Federal Home Loan Banks) to become more active in the primary and secondary real estate markets. It is in part due to these noteworthy actions, which significantly improved liquidity, that we are becoming more positive on the market. We are also very encouraged by the apparent availability of capital for financial institutions with broad franchise value.
While markets have begun to improve since the proposed acquisition of Bear Stearns by JPMorgan Chase and the Fed expanded its lending activities, we expect preferred issuance levels to remain high, which could keep the market from running higher. Financial institutions are likely to continue to need additional capital amid mounting credit reserves and write downs. Institutions will also be seeking capital for expansion. For instance, we believe that Freddie Mac and Fannie Mae may follow last year’s record-setting issuance with another tranche of preferreds to expand their capital base in conjunction with their recently expanded ability to purchase and guaranty mortgage assets. Conversely, we believe issuance levels in other sectors, such as REITs, are likely to remain low compared with historical standards in part due to the much higher credit spreads the issuers will have to pay.
We have maintained a generally more defensive bias, but are also focusing on market shifts signifying improving conditions. Within the corporate sector, we have liked companies with defensive business models or that deliver essential services, such as utilities, telecommunications and property & casualty insurance. However, at the margin adding exposures to the right financial services companies makes sense to us now given very wide credit spreads and improving market conditions. We like the largest institutions with high franchise value and proven access to capital and liquidity. We are also shifting our focus to issues that offer higher upside potential with limited additional risk and strong fundamentals—those that we believe can perform well as markets improve but which are nonetheless somewhat defensive in an uncertain economic environment.
The views and opinions in the preceding commentary are as of the date of publication and are subject to change. This material represents an assessment of the market environment at a specific point in time, should not be relied upon as investment advice and is not intended to predict or depict performance of any investment.
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