There are three reasons why investors should be considering preferreds in a rising rates environment.
[Brian Cordes]: There are three reasons why investors should be considering preferreds in a rising rates environment.
Its low duration structures, its wide credit spreads and its high levels of income.
Typically when we begin a conversation on preferreds with investors, their minds will go to the $25 par preferreds that are fixed rate in perpetual and they tend to have longer duration.
That's not the type of security that’s attractive to them in today's rising rate environment.
That type of preferreds commonly found in the retail preferred market, which represents only 18% of what is a $973 billion dollar universe.
The remaining 82% is in the institutional preferred market and in this market the investors demand a coupon that will reset itself at a point in the future.
As such, they’ll come with coupons structures of fixed to float or fixed to fixed, which have much shorter durations.
Because the institutional market is so much larger than the retail market, a little bit more than 2/3 of the preferred universe actually has a duration of five years of less.
And for us as an active manager we have access to the entire preferred universe and we’ll look to allocate more of these shorter duration securities in a period like today's rising rate environment.
The benefits of this could be seen as recently as 2013.
2013 was the year of the taper tantrum where we saw the US 10-year yield go from 1.6% in May to 3% by the end of December.
During that period the institutional preferred market returned 4.6 %, while the retail preferred market declined 4.8%.
When you think about how a rising rate environment may impact the credit risk associated with preferreds, one needs to think about the makeup of the universe itself.
Nearly ¾ of the preferred universe is issued by banks and insurance companies, because preferred will count towards their regulatory capital requirements.
So back during the financial crisis we saw a credit spreads widen dramatically and since that point in time as we've been operating under a much harsher regulatory environment, the credit quality of these companies has improved dramatically.
Yet we have not seen spreads narrow back to where they were prior to the financial crisis.
We also need to consider why interest rates are moving higher.
Interest rates are currently moving higher because the economy is improving.
Banks and insurance companies tend to benefit from that type of environment more than any other industry as they see improvements in their net interest margins and better returns on their investment portfolios.
To the extent that that reduces their credit risk combined with the fact that their credit quality has improved since the financial crisis, we believe you could see further spread compression in the preferred space.
Preferreds offer some of the highest tax advantage income in the markets today.
That high level of income can help offset any price declines we may see from a rising rate environment.
That is one of the reasons why we've seen preferreds generate such consistent returns over time.