Moody’s methodology change has led to increased issuance of hybrid securities, creating opportunities for investors with attractive yields, reduced extension risk, and greater diversification in the preferred securities market.
KEY TAKEAWAYS
- Moody’s methodology change spurs hybrid issuance: A shift in Moody’s ratings methodology has driven corporations, particularly utilities, to issue hybrid securities as a tax-efficient strategy to obtain equity credit.
- Attractive investment opportunities: The new hybrid securities offer high yields (6.5% to 7%), favorable structures that reduce extension risk, and greater diversification potential, making them attractive to investors.
- Market diversification potential: The increase in non-financial issuers could broaden the preferred securities market, which is currently dominated by banks and insurance companies, enhancing diversification in fixed-income portfolios.
Transcript
Preferred securities are the top-performing fixed income category in 2024. And they continue to offer the highest yields among investment-grade securities—income that is often tax-advantaged for U.S. investors.
Today we’ll look at recent developments that we believe are favorable for investors from both a short- and long-term perspective.
New issuance in the preferred securities market this year is on pace to surpass its trailing five-year average. Yet, the technical backdrop for preferreds is quite positive, in our opinion, for several reasons.
While preferred new issuance has risen sharply in 2024, many of the deals coming to market are replacing securities that are being redeemed, resulting in limited net new supply. In fact, the size of the exchange-traded $25 par portion of the preferred market has shrunk as a result of net redemptions. This is in contrast to other areas of fixed income, where net new supply has grown this year.
Bank preferred refinancing activity has been notably strong this year. Taking advantage of current tight credit spreads, European banks have increasingly tendered securities that are callable in the near term, while U.S. banks have refinanced or redeemed higher-cost preferreds, some of them being floating-rate.
A large portion of the new issuance is driven by a recent change in the methodology used by ratings agency Moody’s. As a result of the change, corporations are issuing hybrid securities as a tax-efficient strategy to obtain equity credit.
This has spurred utilities, with many being new to the preferred market, to issue hybrids. In some cases, utilities replaced previously issued perpetual securities with new hybrid securities. Hybrids are long-term, junior subordinated deferrable debt securities with set maturities that pay interest income, in contrast to perpetual securities that pay dividend income and are, therefore, less tax efficient for the issuer.
Most of the new utility hybrids are investment grade and come with attractive yields in the six and a half to seven percent range. In many cases, they’re also being issued with favorable structures that partially lose equity credit after ten years, at which time they are likely to be called, since, after that, they would be considered higher-cost debt funding. Since these new issues effectively remove extension risk after ten years, investors are finding that the structure and higher yields offer the potential for attractive risk-adjusted returns. Coming from a stable, non-financial sector, they also provide greater diversification.
Longer term, we believe Moody’s methodology change will lead to a greater level of gross issuance from non-financial companies. Bank and insurance issues currently comprise roughly 70% of the preferreds market. So a broadening of the market could increase the diversification potential of preferreds in fixed income portfolios.
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Index definitions. OTC preferreds represented by ICE BofA Investment Grade Institutional Capital Securities Index. Retail preferreds represented by ICE BofA Core Fixed Rate Preferred Securities Index. Contingent capital securitiesrepresented by ICE USD Contingent Capital Index. Investment-grade corporate bonds represented by ICE BofA US Corporate Index.
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.
Contingent capital securities (CoCos). CoCos are debt or preferred securities with loss absorption characteristics built into the terms of the security, for example a mandatory conversion into common stock of the issuer under certain circumstances, such as the issuer’s capital ratio falling below a certain level. Since the common stock of the issuer may not pay a dividend, investors in these instruments could experience a reduced income rate, potentially to zero, and conversion would deepen the subordination of the investor, hence worsening the investor’s standing in a bankruptcy. Some CoCos provide for a reduction in the value or principal amount of the security under such circumstances. In addition, most CoCos are considered to be high yield securities and are therefore subject to the risks of investing in 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 a portfolio's duration. The duration of a security will be expected to change over time with changes in market factors and time to maturity.
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