After the interest rate–driven declines of last year, we believe many fixed income investments represent a compelling opportunity for investors. While central banks around the globe may raise rates further, a great deal of additional tightening is priced into rate curves, and inflation, while sticky, is on the decline. Rate-hiking cycles in developed economies will likely end in the coming months, setting the stage for potentially strong total returns in fixed income markets, based on historical experience (Exhibit 1).

We believe preferred securities have great appeal for term fixed income allocations. Preferreds can offer both quality (most of the market is investment grade) and high income potential, typically well above that offered by investment-grade bonds (with tax advantages for many U.S. investors). These characteristics have supported their strong total returns over time. Preferreds may also offer diversification benefits, with low correlations to other fixed income assets and exposure to less cyclical businesses. Most preferred securities also have coupon resets that limit interest rate risk.

Investment-grade U.S. dollar preferred securities have performed remarkably well following the end of Federal Reserve rate-hiking cycles, producing an average 12-month return of 14.2% and an 8.2% average two-year annualized total. Preferred securities have also outperformed other fixed income classes, on average, coming out of rate-hiking cycles since 1990.

Yields and average one-year total return following last rate hike (%)

At February 15, 2023. Source: ICE BofA, Cohen & Steers analysis.
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 market forecast set forth in this presentation will be realized. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin. Preferred securities represented by the investment-grade-only ICE BofA Fixed Rate Preferred Securities Index (credit quality: BBB), investment- grade bonds represented by ICE BofA Corporate Master Index (credit quality: A-), high-yield bonds represent by ICE BofA High Yield Master Index (credit quality: B+). See end notes for index associations, definitions and additional disclosures.

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Preferreds (also known as capital securities or hybrid securities) are typically a form of equity or junior subordinate debt, but they act like bonds, offering a set face value and a predetermined rate of income. Because they sit lower (subordinated) in the capital structure than bonds, preferreds would fare worse in a bankruptcy, and payments could be at risk in a stressed situation. Recognizing this, preferred securities also bear lower credit ratings than the senior debt of the same issuer, though most are still investment grade as most issuers are high quality.

To compensate for the additional risks, preferred securities typically pay much higher rates of income than bonds from the same issuer. The “subordination premiums” that preferreds offer vary due to market factors, as well as by issuer, quality and security structure. However, income rates among high-quality preferreds are typically 150–200 basis points higher than for senior debt of the same issuer (and are normally 200+ basis points higher for below-investment- grade preferreds). The long-term spread of investment-grade preferreds over investment-grade corporate bonds has been 190 basis points.⁽¹⁾ This additional income has historically driven preferreds’ strong relative returns (Exhibit 2).

In recent periods, preferreds’ good relative returns have been supported both by their high income rates and their shorter average durations, which stem from the regular coupon resets that most preferred securities offer. But over long periods of time (5–10 years), fixed income total returns have been driven mainly by income, including income reinvestment, and by default rates.

Total returns by asset class (%)

At January 31, 2023. Source: ICE BofA, Cohen & Steers.
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. (a) The blended benchmark is represented by 50% ICE BofA Fixed Rate Preferred Securities Index and 50% ICE BofA Capital Securities Index through 12/31/2016; 60% ICE BofA US IG Institutional Capital Securities Index, 30% ICE BofA Core Fixed Rate Preferred Securities Index and 10% Bloomberg Developed Market USD Contingent Capital Index through 12/31/2018; and 60% ICE BofA US IG Institutional Capital Securities Index, 20% ICE BofA Core Fixed Rate Preferred Securities Index and 20% Bloomberg Developed Market USD Contingent Capital Index for periods thereafter. See end notes for index associations, definitions and additional disclosures..

(1) ICE BofA Fixed Rate Preferred Securities Index (credit quality: BBB) vs. ICE BofA Corporate Master Index (credit quality: A-) from 1/31/1997 to 12/31/2022. The spread between high-yield bonds (ICE BofA High Yield Master Index; credit quality: B+) and preferred securities for the same time period was 209 bps.

Although high income is a primary driver of fixed income returns, it doesn’t tell the whole story. For example, over the last 10 years, U.S. high-yield bonds have paid 125–175 basis points more per year in income than investment-grade preferreds. Yet, as Exhibit 2 shows, the two have similar long-term return profiles.

This performance convergence is primarily due to high-yield bonds’ meaningfully higher default rate over time. High-yield bonds are issued mainly by economically sensitive, cyclical industries (such as energy, basic materials, media and retail), as well as by more highly leveraged companies. Since 2000, annual high-yield defaults have averaged more than 4%, and at times they have been significantly higher (Exhibit 3).

The preferred market is much higher quality, with most preferreds having investment-grade ratings, and their very low long-term default rates reflect this quality. What drives the quality? Preferreds are deeply subordinated, and dividend payments can be deferred or omitted in times of stress. Hence, investors demand tested and stable business models. Preferreds are primarily issued by high-quality, highly regulated companies (such as banks and insurance companies) and others offering steady, predictable cash flows (such as utilities)—sectors with historically low comparative bond default rates.⁽¹⁾

Recovery rates from high-yield defaults (the extent to which principal and accrued interest can be recovered, expressed as a percentage of face value) vary but have typically been around 40%, leading to a net loss of about 2.5% of annual returns over long periods. In effect, typical default cycles in high-yield bonds can wipe out years of clipping higher coupons, so their historical returns ultimately have been merely on par with what investors earn from preferred securities.

Historical U.S. 12-month default rate (%)

At December 31, 2021. Source: Moody’s Investors Service, Cohen & Steers.
Data quoted represents past performance, which is no guarantee of future results. 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. Investment-grade bonds are represented by securities rated Baa3 and higher by Moody’s; high-yield bonds are represented by issues rated Ba1 and lower. See end notes for additional disclosures.

(1) Per Standard & Poor’s 2021 Default, Transition and Recovery report, covering 1981 through 2021, the weighted-average annual U.S. corporate default rates were 0.87% for financial institutions (including during the global financial crisis), 0.38% for insurance, and 0.40% for utilities. These are the largest sectors found in the preferred securities market. This compared with 4.09% for energy and natural resources and 2.23% for aerospace/automotive/capital goods/metal, for instance—larger sectors found in the high-yield market. Default rates have been closely aligned with security ratings over time, and preferred securities’ ratings reflect both probability of default as well as severity. Ratings agencies provide ratings on preferreds that place them appropriately on their ratings scales in consideration of these factors. Moody’s stated explicitly in its 2012 study of Preferred Stock Impairments and Recoveries (encompassing 1980–2012) that impairment rates on preferred securities (including dividend omissions, among other events) were “…similar to average cumulative default rates of global corporates overall and by like rating category.”

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The array of security structures available in the preferred market, including fixed-rate, fixed-to-reset and floating-rate securities, gives active managers an extensive toolbox to add potential value for investors. The complexity of these instruments and the ongoing evolution of the preferred securities market may provide skilled managers with opportunities to generate excess returns and manage interest rate and credit risk amid changing global market environments.

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