3 reasons to consider preferreds when rates are rising

3 reasons to consider preferreds when rates are rising

10 minute read

September 2022

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Preferred securities have characteristics that can potentially help mitigate the effects of rising interest rates.

KEY TAKEAWAYS

  • Preferreds offer some of the highest yields in investment-grade fixed income
  • Preferreds can be an attractive alternative to high-yield bonds
  • Rates are rising but preferred issuers are in good shape

1. Preferreds offer some of the highest yields in investment-grade fixed income

Preferred securities historically have had significant yield advantages over other types of investment-grade fixed income securities such as corporate and municipal bonds (Exhibit 1). That remains the case after this year’s broad market repricing (yields have been pushed higher across fixed income, and now reflect a good deal of negative expectations in our view).

Preferreds’ extra yield can potentially help cushion some of the impact of rising interest rates on total returns. We believe that the above-average yields and modest durations (due to widely available securities with fixed-to- reset coupon features) on many preferreds is an attractive combination in today’s environment. As well, preferreds can offer qualified dividend income (QDI) tax advantages in the U.S.

EXHIBIT 1
Preferreds absolute and relative yields remain attractive

Yield to maturity, June 30, 2022

Preferreds absolute and relative yields remain attractive

2. Preferreds can be an attractive alternative to high-yield bonds

Looking more closely at preferreds vs. high yield bonds, the yield differential has widened in recent months, as high yield has more aggressively priced in the risk of slowing growth/recession. High yield currently offers about 250 basis points of income over preferreds, compared with a long-term average of 209 basis points (Exhibit 2). However, the quality of preferreds is triple B on average (based on the domestic preferred market as of June 2022), which is five notches above the single B+ rating of high yield. As such, preferreds appear better positioned than high yield to help mitigate any further slowdown caused by rising rates, and historically have tended to have significantly lower default rates than high yield during recessions/slowdowns.

EXHIBIT 2
Risk-adjusted yield spreads could indicate value for Long-term average spread (1997-2022): 209 bps preferreds

Yield comparison—high-yield bonds vs. preferred securities January 1997–June 30, 2022

Risk-adjusted yield spreads could indicate value for preferreds
Yields on preferred securities appear attractive vs. high-yield bonds on a risk-adjusted basis.

3. Rates are rising but banks are in good shape

While the Federal Reserve’s rate increases could drive down economic growth, banks—the main issuers of preferred securities—are operating from a position of strength. For U.S. banks, core capital ratios, which measure the amount of non-preferred equity capital relative to risk-weighted assets, are close to 11% on average, which is well above required minimums, and much higher than the 7%
average going into the 2008 financial crisis (Exhibit 3). The story is similar in Europe.

EXHIBIT 3
Capital strength in U.S. and European banks near all-time highs
Capital strength in U.S. and European banks near all-time highs
Current positioning

In light of the prospect of tighter financial conditions and an increasingly uncertain macro backdrop, we have become more defensive in both our core preferreds and low-duration preferreds strategies. We have reduced some of our credit overweight while favoring higher-quality and higher-reset (spread over benchmark upon coupon reset) structures. Specifically, we have shortened portfolio rate and spread durations by increasing investments in shorter-duration preferreds that both 1) have coupon resets within 1 to 5 years; and 2) have high reset levels.

FURTHER READING

3 Reasons to own preferred securities today

3 Reasons to own preferred securities today

February 2024 | 6 mins

We believe an exceptional buying opportunity for preferred securities may exist today.

Putting recent commercial real estate debt headlines into perspective

Putting recent commercial real estate debt headlines into perspective

February 2024 | 17 mins

We believe the developments at New York Community Bancorp are not indicative of a systemic CRE debt problem or broader systemic stress across regional banks, but they do deserve some further explanation.

What impending resets mean for preferred securities

December 2023 | 4 mins

Upcoming call dates/dividend resets provide preferred securities with a potential catalyst in today's uncertain market. Primarily issued by investment-grade-rated companies, preferred yields are currently in the 7–9% range. Most preferreds come with dividend-resetting structures, potentially leading to income growth for investors in the face of sustained interest rates. Additionally, many securities are selling at 10–20% discounts to par value. Given their historical trend of trading near par, these deep discounts present significant potential for capital appreciation for patient investors.

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