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While preferreds and other fixed income groups have faced macro headwinds so far in 2022, we believe the longer-term outlook for preferreds remains intact.
- Fundamentals for preferred issuers remain attractive
- Valuations offer select opportunities, but require active management, in our view
- We have taken a more defensive position for rates and credit
Backdrop: A challenging start to 2022 for fixed income
Preferred and other fixed income securities started 2022 on a difficult note amid higher inflation and the prospect of monetary tightening, with Russia’s invasion of Ukraine adding more uncertainty to the mix.
In March, the Federal Reserve raised short-term interest rates for the first time since 2018. We expect the Fed to continue a tightening cycle as it takes a more aggressive approach to fight high inflation readings.
The Russia-Ukraine war has the potential to exacerbate inflation due to an increase in a broad spectrum of commodities prices, most notably oil and gas. As it stands, the Fed is projecting at least several more rate hikes in 2022. Given the current economic backdrop, we believe it makes sense to take an increasingly hawkish stance.
Fundamentals and strength of preferred issuers remain attractive
We acknowledge the risk that tighter Fed policy could drive down economic growth. But banks, the main issuers of preferred securities, are entering this uncertain period from a position of strength. For U.S. banks, core capital ratios— which measure the amount of Tier 1 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 1).
Capital strength in U.S. and European banks near all-time highs
Core capital ratios of major European and U.S. banks(1)
At September 30, 2021. Source: Cohen & Steers, Morningstar, ICE BofA, SNL and Institute of Supply Management (ISM).
Data quoted represents past performance, which is no guarantee of future results. The information presented is for illustrative purposes only and does not reflect information about any account managed or serviced by Cohen & Steers. There is no guarantee that any historical trend illustrated above will be repeated in the future or any way to know in advance when such a trend might begin. The views and opinions are as of the date of publication and are subject to change without notice.
(1) The core capital ratio is the ratio of core (common equity) capital to total risk-weighted assets. Banks must meet a minimum core capital requirement as dictated by local banking laws and regulations. Higher core capital ratios have helped to strengthen banks’ balance sheets and to improve their credit quality.
It’s a similar story in Europe. While we acknowledge concerns about the economic impact of the war, we believe European banks are well positioned to mitigate the risk of direct credit exposure to Russia and Ukraine, as well as the potential second-order effects on European economies. By our estimates, assets at direct risk are less than 1% of all European bank credit exposures. Some banks have higher direct credit exposure than others, but in general, although there are no guarantees, we expect any losses to have a limited and manageable capital impact.
In addition, loan loss reserves for European banks are at conservative levels as a sizable amount of Covid reserves have yet to be released. Notably, the head supervisor for European banks has said that regulators do not expect to limit European banks’ shareholder dividends like they did during the height of Covid.
The negative economic impact of the war could also be mitigated with more flexible monetary policy, meaning that the European Central Bank could be less hawkish than expected. And governments in the region may look to soften the economic impact through fiscal support (resurrecting the Covid playbook), including the possibility of joint bond issuance to fund higher energy and defense spending.
Higher rates have the potential to aid bank profits
In general, another fundamental factor that can support preferred investors is banks’ positive earnings sensitivity to rising rates. For example, about two- thirds of U.S. bank interest-rate sensitivity is on the short end of the yield curve. Some bank loans are poised to reprice higher, and we estimate that a 100-basis-point move up in rates could increase bank profitability by more than 15%, on average.
Valuations offer select opportunities
Preferreds are subordinated to the issuing company’s senior debt, so it’s important to look at how much compensation preferreds offer over traditional investment-grade bonds. The yield on investment-grade exchange-traded preferreds is about 5.1% (as of March 31, 2022), compared with a yield of about 3.6% for single A corporate bonds.(1)
In the first quarter of 2022, the spread between exchange-traded preferreds and investment-grade bonds compressed by about 57 basis points, to 148 basis points. While preferreds’ yield advantage is now tighter than the longer- term average (1/97 through 3/22) of 190 basis points, we think the spread compression makes sense, given the solid fundamentals of preferred issuers. The tighter spread differential on this part of the preferred market now offers less cushion against rising interest rates and wider spreads, so security selection remains important.
Yields on preferred securities appear attractive vs. high-yield bonds on a historical basis.
Yields on investment-grade exchange-traded preferreds look attractive relative to high-yield debt, as high yield now only offers about 107 basis points of income over preferreds, compared with a long-term average of 209 basis points (Exhibit 2). Issuance within high yield has slowed this year, in part because issuers have turned to the leverage loan market, which may help explain the tighter valuations in high yield.
Preferreds offer competitive yields vs. lower-credit high- yield debt
Yield comparison—high-yield bonds vs. preferred securities January 1997 – March 31, 2022
At March 31, 2022. Source: ICE BofA.
Data quoted represents past performance, which is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated above will be repeated in the future or any way to know in advance when such a trend might begin.
Debt securities including preferred securities, corporate bonds, municipal bonds and high yield bonds generally present various risks, including interest rate risk, credit risk, call risk, prepayment and extension risk, convertible securities risk, and liquidity risk. The mention of specific securities is not a recommendation or solicitation for any person to buy, sell or hold any particular security and should not be relied upon as investment advice. Note: Yields shown on a yield-to-maturity basis.
(1) ICE BofA High-Yield Master Index tracks the performance of U.S. dollar-denominated below-investment-grade corporate debt publicly issued in the U.S. domestic market.
(2) ICE BofA Fixed Rate Preferred Securities Index tracks the performance of fixed-rate U.S. dollar-denominated preferred securities issued in the U.S. domestic market.
Long-term average starts 1/31/1997 and ends 3/31/2022. Based on monthly observations. Yield spread is the difference between yields on differing debt instruments, calculated by deducting the yield of one instrument from another.
High-yield debt does have generally lower durations than preferreds. But the quality of preferreds is triple B on average (based on the exchange-traded market as of March 2022), which is five notches above single B+ rating of high yield. Also, most preferreds pay qualified dividend income, which is taxed at just 23.8% for the highest tax brackets, compared with a 40.8% income tax rate for high yield bonds. Therefore, on an after-tax basis, high quality preferreds may offer more income than high yield—with substantially better credit quality.
While we have seen a sharp repricing across preferreds that has created valuation opportunities, we believe the opportunities are nuanced, as parts of the market offer the potential for attractive risk-adjusted returns, while other parts of the market offer less potential cushion against rising rates. In our view, the best opportunities can be found among preferreds with coupons that are fixed-to-fixed or fixed-to-float. At the call date (if the security is not called), these coupons reset at a benchmark rate, such as the London Interbank Offered Rate (LIBOR), the Secured Overnight Financing Rate (SOFR) or 5-year Treasuries, plus the original credit spread.
As interest rates rise, the coupons of such fixed-to-reset securities will rise too, as they reset over higher rates. Effectively, the expected internal rate of return of these securities can turn more attractive, offering the potential for certain preferreds to outperform other fixed income assets.
A more defensive position
Given the prospect of tighter financial conditions and an increasingly uncertain macro backdrop, we have become more defensive in both our preferreds and low-duration preferreds strategies. We have reduced some of our credit overweight while favoring more-defensive security structures such as higher-quality and higher-reset (less rate-sensitive) structures. Specifically, we have shortened portfolio durations by increasing investments in shorter-duration preferreds that have high resets in the next few years and decreasing exposure to longer-duration fixed-rate securities.
We’ve also been favoring higher coupon securities, to potentially help smooth out interest-rate volatility. The higher income acts as a cushion, mitigating potential negative price returns, as rates rise.
While higher inflation, and the higher interest rates that typically accompany it, present challenges across fixed income, we believe active management can help mitigate the risks.
Our preferreds strategies have ample coupon reset structures
At March 31, 2022.
Holdings are subject to change without notice. Portfolio weightings are subject to change without notice. Based on a representative account which was chosen because it best illustrates the strategy’s investment policy and objective.
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Market developments at Credit Suisse
The government-backed deal for UBS to acquire Credit Suisse will trigger a complete write-down of the nominal value of all Credit Suisse additional tier 1 bonds. We believe Credit Suisse is most likely to be an isolated incident, while we have been reducing our portfolios’ exposure to Credit Suisse significantly over the past several months.
Addressing developments at regional banks
The U.S. government's actions to minimize risk across the banking industry following the events of Silicon Valley Bank and Signature Bank have strong potential to prevent further bank runs and subsequent bank failures. But scrutiny of some regional banks will persist.
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Data quoted represents past performance, which is no guarantee of future results. The views and opinions presented in this document are as of the date of publication and are subject to change. There is no guarantee that any market forecast set forth in this document will be realized. This material represents an assessment of the market environment at a specific point in time and should not be relied upon as investment advice, does not constitute a recommendation to buy or sell a security or other investment and is not intended to predict or depict performance of any investment.
This material is not being provided in a fiduciary capacity and is not intended to recommend any investment policy or investment strategy or to account for the specific objectives or circumstances of any investor. We consider the information to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of appropriateness for investment. Cohen & Steers does not provide investment, tax or legal advice. Please consult with your investment, tax or legal professional regarding your individual circumstances prior to investing. No representation or warranty is made as to the efficacy of any strategy or fund or the actual returns that may be achieved.
Risks of investing in preferred securities. An investment in a preferred strategy is subject to investment risk, including the possible loss of the entire principal amount that you invest. The value of these securities, like other investments, may move up or down, sometimes rapidly and unpredictably. Our preferred strategies may invest in below-investment-grade securities and unrated securities judged to be below investment-grade by the Advisor. Below-investment-grade securities or equivalent unrated securities generally involve greater volatility of price and risk of loss of income and principal, and may be more susceptible to real or perceived adverse economic and competitive industry conditions than higher-grade securities. The strategies’ benchmarks do not contain below investment-grade securities.
Duration Risk. Duration is a mathematical calculation of the average life of a fixed-income or preferred security that serves as a measure of the security’s price risk to changes in interest rates (or yields).Securities with longer durations tend to be more sensitive to interest rate (or yield) changes than securities with shorter durations. Duration differs from maturity in that it considers potential changes to interest rates, and a security’s coupon payments, yield, price and par value and call features, in addition to the amount of time until the security matures. Various techniques may be used to shorten or lengthen the Fund’s duration. The duration of a security will be expected to change over time with changes in market factors and time to maturity.
Cohen & Steers Capital Management, Inc. (Cohen & Steers) is a registered investment advisory firm that provides investment management services to corporate retirement, public and union retirement plans, endowments, foundations and mutual funds. Cohen & Steers U.S. registered open-end funds are distributed by Cohen & Steers Securities, LLC, and are available only to U.S. residents.