The preferred securities asset allocation advantage

The preferred securities asset allocation advantage

12 minute read

February 2023

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Preferreds offer long-term return potential superior to investment-grade and comparable to high-yield bonds, with diversification and quality advantages.

KEY TAKEAWAYS

  • Preferred securities are attractive now, having repriced in 2022 and with the rate-hiking cycle nearing an end, in our view.
  • Income has been the largest driver of bond returns, and quality preferred securities have out-earned investment-grade debt, historically leading to material outperformance for long-term investors.
  • High-yield bond default rates largely erase the relative income advantage the category has over the higher quality preferred securities market.

Preferred securities are attractive at current levels

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.

EXHIBIT 1
Preferreds typically have strong performance following rate-hiking cycles

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

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

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Preferred securities have historically offered higher yields and superior long-term returns than investment-grade corporate bonds

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.

EXHIBIT 2
Preferreds frequently outperform other fixed income

Total returns by asset class (%)

Total returns by asset class

High-yield bonds’ default rates counteract their yield premium

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.

With preferreds, investors can earn essentially the same returns as with high-yield bonds, but from higher-quality, less volatile securities.
EXHIBIT 3
Normal cyclical defaults offset high yield’s income edge

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

Historical U.S. 12-month default rate

Generating alpha and managing risk

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.



FURTHER READING

3 Reasons to own preferred securities today

3 Reasons to own preferred securities today

April 2024 | 5 mins

We believe an exceptional buying opportunity for preferred securities may exist today.

Tax-smart income alternatives

Tax-smart income alternatives

March 2024 | 17 mins

Strategies with inherent tax efficiencies may help investors diversify sources of income and potentially keep more of what they earn.

Understanding quality, ratings and long-term compensation of preferred securities

Understanding quality, ratings and long-term compensation of preferred securities

March 2024 | 38 mins

Preferreds provide attractive income and total returns from high-quality securities; despite added risks, default rates can be lower than credit ratings suggest.

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