Improving global economic growth and the potential for new stimulus policies in the U.S. may push interest rates higher over time. We believe important keys to navigating the potential impact of higher rates on preferred securities include structure selection and the active management of credit risk. We discuss these and other elements of our toolkit below.
Preferred Securities Provide Diversifcation by Rate Structure
Many investors perceive preferred securities as being highly interest-rate sensitive due to their perpetual structures. But the preferred market is actually composed of securities with a variety of structures that have the potential to buﬀer a portfolio’s interest-rate risk.
Preferred securities are issued and traded in two distinct markets: 1) $25 par preferred securities that trade on an exchange; and 2) $1,000 par preferred securities that trade over the counter (OTC).
- The security typical to the exchange-traded market is a callable fxed-rate issue with a long duration. This type of security is absent from the OTC market.
- The security types dominant in the OTC market are those structured as fxed-to-ﬂoating-rate securities, which pay a fxed rate over an initial period, after which they can be called or reset to a ﬂoating rate— a feature that reduces their duration, or sensitivity, to interest-rate risk.
- The third type of security is a ﬂoating-rate security, which eﬀectively has a near-zero duration because it resets frequently based on movements of a benchmark interest rate—with virtually no interest-rate risk.
Over the course of an interest-rate cycle, we feel it is critical to have access to both markets and all three security structures, with the understanding that one of these may perform much better than another depending on market conditions.
An Active Approach to Managing Credit and Interest-Rate Risk
We believe that active management of interest-rate and credit risks will continue to be critical in the coming quarters. Our focus on credit means that we seek out attractive spread relationships versus Treasury issues. These spreads can help protect investors over time and potentially smooth total returns. An important focus for Cohen & Steers is on fxed-to-ﬂoating instruments, which are tied to the shorter end of the yield curve. We can also access foreign-currency issues, which may not be inﬂuenced by U.S. rates.
Some of the viable tools and strategies used by professional managers of preferred securities portfolios are identifed and summarized below:
High coupons and wide credit spreads. In both the OTC and exchange-listed markets, we are focused on securities that are not only oﬀering relatively high income rates and above-average spreads, but also good amounts of call protection given our expectation that longer-term interest rates will remain low for the near term. While we are more cautious in some areas, we also see specifc credit catalysts driven by regulatory changes at banks and general economic improvements.
A mixture of structures. The interest-rate sensitivity of a preferred security is largely the result of its structure. Fixed-to-ﬂoat and pure ﬂoating-rate issues are generally the least sensitive to interest rates, as their coupons reset, often frequently. But interestingly, these structures can also oﬀer more call protection—often ten years versus the typical fve years for fxed-rate exchange-listed preferred securities. This potentially provides more upside if rates stay low and oﬀers less price risk should they turn higher.
Foreign-currency issues. Preferred securities issued in foreign currencies can help diversify interest-rate risk, as they tend to react to the yield curve of their domestic market, which is mostly a function of local economic and monetary cycles. Monetary policy in Europe, for instance, is now far more accommodative than in the U.S., where the Federal Reserve has been incrementally raising interest rates.
Use of hedging to reduce interest-rate risk. Cohen & Steers can engage in interest-rate hedging if and when we fnd it desirable and/or necessary. Our in-house hedging capabilities are supported by an experienced quantitative and derivatives team, which may purchase, sell or enter into any derivative contract or option, including various interest-rate transactions, foreign-currency transactions and other similar transactions.
While we believe it is valuable to have these hedging tools at our disposal, we approach them tactically and currently believe that the most eﬀective method of managing interest-rate risk over time is careful and active portfolio construction.
As a professional manager of preferred securities, we believe that the depth of tools already available— such as security structures, income rates and credit spreads—can help protect investors against interestrate risk when rates rise. We also note the healthy eﬀect of high current income on total returns over time. Income in and of itself can provide total-return protection. We have multiple types of hedging strategies at our disposal, but we strive to avoid those that may erode a portfolio’s earnings, such as an ongoing hedge strategy with a low probability of a longer-term payoﬀ. Rather, we believe active management, potentially with strategic hedging, is the best course.
Data quoted represents past performance, which is no guarantee of future results. This material is for informational purposes. It does not constitute investment advice or a recommendation or oﬀer of a particular security. We consider the information herein to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of suitability for investment. The views and opinions in the preceding commentary are as of the date of publication and are subject to change without notice. There is no guarantee that any market forecast set forth in this presentation will be realized. Investors should consult with their advisors for advice regarding their particular circumstances. No representation or warranty is made as to the efcacy of any particular strategy or the actual returns that may be achieved. There is no guarantee that any historical trend discussed above will be repeated in the future, and there is no way to predict precisely when such a trend will begin.
Risks of investing in preferred securities. Investing in any market exposes investors to risks. In general, the risks of investing in preferred securities are similar to those of investing in bonds, including credit risk and interest-rate risk. As nearly all preferred securities have issuer call options, call risk and reinvestment risk are also important considerations. In addition, investors face equity-like risks, such as deferral or omission of distributions, subordination to bonds and other more senior debt, and higher corporate governance risks with limited voting rights.
Risks associated with preferred securities diﬀer from risks inherent with other investments. In particular, in the event of bankruptcy, a company’s preferred securities are senior to common stock but subordinated to all other types of corporate debt. It is important to note that corporate bonds sit higher in the capital structure than preferred securities, and therefore, in the event of bankruptcy, will be senior to the preferred securities. Municipal bonds are issued and backed by state and local governments and their agencies, and the interest from municipal securities is often free from both state and local income taxes. Treasury securities are issued by the U.S. government and are generally considered the safest of all bonds as they are backed by the full faith and credit of the U.S. government as to timely payment of principal and interest.
Preferred funds 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.
This commentary must be accompanied by the most recent Cohen & Steers fund factsheet(s) and summary prospectus if used in conjunction with the sale of mutual fund shares.
Cohen & Steers U.S.-registered open-end funds are distributed by Cohen & Steers Securities, LLC, and are available to U.S. residents only.
Cohen & Steers Capital Management, Inc. (Cohen & Steers) is a registered investment advisory frm that provides investment management services to corporate retirement, public and union retirement plans, endowments, foundations and mutual funds. Cohen & Steers UK Limited is authorized and regulated by the Financial Conduct Authority (FRN 458459).
Cohen & Steers Japan, LLC is a registered fnancial instruments operator (investment advisory and agency business with the Financial Services Agency of Japan and the Kanto Local Finance Bureau No. 2857) and is a member of the Japan Investment Advisers Association.