The Fed’s rate-hiking cycle could be drawing to a close

The Federal Reserve’s aggressive rate hikes in 2022 appear to be having the desired effect. Demand has slowed with the economy and price increases appear to have peaked. In October, the year-over-year change in the U.S. Consumer Price Index was a better-than-expected 7.7%, down from 9% in June.

Judging by their recent public statements, central bankers are likely to slow the pace of hikes, but additional rate tightening is expected in the near term. The futures market indicates the overnight lending rate will reach a terminal point close to 5% by May 2023. Moreover, the five-year breakeven inflation rate—derived from five-year Treasury inflation-protected securities—implies that market participants expect the Fed will succeed sooner rather than later and that inflation in the next five years will average around 2.5% (Exhibit 1).

That dovetails with our expectations for inflation to ease considerably in 2023. Although, inflation may remain higher than it was during the pre-pandemic, post-Global-Financial-Crisis recovery—stemming from a confluence of supply- and demand-side considerations.

Yield curve inversion also clearly points to slowing growth and inflation.

If the past is a guide, preferreds and other segments of the fixed income market may perform well in the coming year.

EXHIBIT 1

Inflation has surprised meaningfully, but forward expectations suggest it will moderate

5-year U.S. Treasury yield and 5-year inflation breakeven

January 2010–November 2022

At November 30, 2022. Source: Bloomberg.
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, and there is no way to predict precisely when such a trend will begin. See end notes for index associations, definitions and additional disclosures.

A bullish setup

The past year’s significant repricing in the fixed income market puts yields on preferreds, corporates, municipals and high-yield bonds currently well above their 10- and 20-year averages. If the Fed succeeds in “breaking” inflation, as we expect, an attractive term investment opportunity may be forming. We believe investment-grade preferreds, many of which currently yield 7–8%, are an attractive long-term investment, offering near-equity-like returns while sitting above common equity holders in the capital structure.

We believe even greater returns may be in store in the coming months. Historically, the end of rate-hiking cycles has seen yields in the bond market move materially lower relatively quickly, as central bankers respond to slowing economic conditions. For example, in the periods since 1990 that followed the end of Fed rate-hiking cycles, preferred securities have produced a one-year return of 14.2%, on average, and a 8.2% average two- year annualized total return (Exhibit 2). Preferreds have also meaningfully outperformed other fixed income classes coming out of rate-hiking cycles.

Good characteristically follows bad

As a result of their high income rates, preferred securities tend to have positive annual total returns in any given year. And rare instances when preferreds post negative calendar year returns are typically followed by meaningful gains in subsequent years. Since 1990, in six of seven years following a negative total return (the 2007 GFC was the exception), preferreds had a positive double-digit total return, with an average of 10.8%; the two-year annualized average return was 10.3%. With preferreds down nearly 13% in 2022 through November 30, we anticipate an attractive rebound in 2023.

EXHIBIT 2

Preferreds typically have strong performance following rate-hiking cycles

Average one-year total return following last rate hike (%)

January 1990–November 2022

At November 30, 2022. Source: Bloomberg.
Data quoted represents past performance, which is no guarantee of future results. The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight. The Federal Open Market Committee (FOMC) meets eight times a year to determine the federal funds target rate. 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, and there is no way to predict precisely when such a trend will begin. See end notes for index associations, definitions and additional disclosures.

Issuers are in excellent financial shape

Banks (the largest issuers of preferreds) enter this period of economic uncertainty from a position of strength. U.S. bank core capital ratios, which measure the amount of Tier 1 capital relative to risk-weighted assets, are now 10.6%, on average; for European banks, it averages 13.3%. Those figures are well above the required minimums and nearly double the capital levels seen before the 2008 financial crisis (Exhibit 3). We note, too, that the calculation methodology has become tougher, so relative capital levels are actually higher than they appear.

Bank earnings are another positive support for preferreds. Growth in banks’ net interest income (the spread between asset yields and funding costs), the most significant contributor to bank earnings, has accelerated at the fastest pace since 1976 and is expected to exceed 20% in 2022. This growth is being fueled by both higher interest rates and robust loan underwriting.

Despite a relatively slow economy, bank loan growth at the end of the third quarter was up more than 10% year over year, compared with only 3% growth at the end of 2021. Factors driving this growth included companies rebuilding inventory and increasing capital expenditures, as well as healthy consumer spending.

The majority of bank lending, including commercial loans and credit card balances, is short-dated and quickly reprices with short-term interest rates, leading to positive asset sensitivity. Bank funding costs, meanwhile, are repricing more slowly, so net interest margins have expanded.

Loan growth and interest income may slow in 2023 but are expected to remain at healthy levels, which we believe will drive earnings growth for the banks even as the economy slows. This level of income provides capital generation and a cushion to absorb potential loan losses.

Banks’ balance sheet strength and income growth (with significant earnings upgrades likely to follow) strongly suggest that preferred dividends will generally remain secure, even in a recession.

EXHIBIT 3

Bank capital levels are nearly twice as strong today as in 2008

Core capital ratios of major U.S. and European banks

June 2008–September 2022

At September 30, 2022. Source: Bloomberg.
Data quoted represents past performance, which is no guarantee of future results. The core capital ratio is the ratio of core (common equity) capital to total risk-weighted assets. Banks must meet a minimum core capital requirement as dictated by local banking laws and regulations. Higher core capital ratios have helped to strengthen banks’ balance sheets and to improve their credit quality. (1) Core capital ratios based on the largest U.S. banks, including Bank of America Corporation, JPMorgan Chase & Co., Citigroup Inc., Wells Fargo & Company, U.S. Bancorp, PNC Financial Services Group, Inc., SunTrust Banks, Inc., BB&T Corporation, Regions Financial Corporation, KeyCorp, M&T Bank Corporation, Comerica Inc., Synovus Financial Corp. and First Horizon National Corporation. (2) Core capital ratios based on the following 15 major European banks: HSBC Holdings Plc, Deutsche Bank AG, BNP Paribas SA, Crédit Agricole S.A., Barclays Plc, Société Générale SA, Banco Santander SA, NatWest Group plc, UBS AG, Credit Suisse Group AG, UniCredit SpA, Lloyds Banking Group Plc, Intesa Sanpaolo SpA, Commerzbank AG and Banco Bilbao Vizcaya Argentaria, S.A. The mention of specific securities is not a recommendation or solicitation for any person to buy, sell or hold any particular security and should not be relied upon as investment advice. See end notes for additional disclosures.

Preferreds can help improve portfolio risk/reward profiles

Tax-advantaged income for individuals

Technically a form of equity, preferred securities behave like bonds, with a set face value and a predetermined recurring coupon. But, because they rank below bonds in a company’s capital structure, preferreds tend to pay higher income rates than similarly rated bonds. In fact, preferreds have historically paid among the highest yields in the investment-grade fixed income universe.

Many preferred securities pay qualified dividend income (QDI), taxed at just 20%, plus the 3.8% Medicare surcharge, for top earners (compared with 37% + 3.8% for investment income). The combination of high income rates and lower taxes has historically given preferreds an after-tax yield advantage relative to other fixed income options (Exhibit 4).

Tax-advantaged income for corporations

Institutions that file taxes as C-corporations in the U.S. may garner tax benefits to U.S. investors from preferred securities investments. Dividends issued directly from one tax-paying C-corp to another are generally eligible for the Dividends Received (tax) Deduction (DRD) for the dividend recipient. This would include a taxable institution that owns the preferred securities of (and hence has an ownership stake in) a taxable C-corp. The DRD is intended to offset triple taxation of dividends.

The extent of the tax deduction depends on the ownership stake, with a minimum of a 50% deduction on dividends received and a maximum of 100% if the corporation owns more than 80% of the dividend-paying company. The DRD benefit can be powerful. By owning preferred securities, eligible buyers will normally receive the minimum deduction—meaning that 50% of the dividend will be exempt from taxation. For a corporate investor with a 21% tax rate, the effective tax on preferred income may fall to just 10.5% ((1–0.5) * 0.21). This means a DRD-eligible preferred paying 7.5% would have a taxable-equivalent yield of approximately 8.5%.

EXHIBIT 4

Preferreds offer attractive tax-advantaged income for U.S. investors

Before- and after-tax yields (%)

At November 30, 2022. 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. An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes. Index comparisons have limitations as volatility and other characteristics may differ from a particular investment. The above is not intended to serve as tax advice. Investors should consult with their respective tax advisors prior to making an investment. (1) Yields shown on a yield-to-maturity basis. (2) Assumes taxation at the highest marginal U.S. Federal income tax rates of 37% for taxable interest income and 20% for QDI, with an additional 3.8% Medicare surcharge on all tax rates. After-tax calculations assumes preferred securities income is taxed at the respective qualified dividend rate and marginal tax rate on a 65/35 blended basis. All other securities reflect full taxation at the respective marginal rates based on income. State and local taxes are not included in these calculations. See end notes for index associations, definitions and additional disclosures.

Low correlations with equity markets and other fixed income asset classes

Preferred securities historically have offered diversification benefits relative to equities and other asset classes (Exhibit 5). Since preferreds tend to behave differently, they may help smooth returns when combined in a broad portfolio.

The low correlations occur partly because banks and insurance companies, the largest issuers of preferred securities, typically are not well represented in other fixed income categories, particularly high-yield bonds, which are dominated by industrial, energy and media companies. Preferreds issuers are highly regulated and tend to benefit from rising interest rates. In further contrast to the high-yield market, preferreds are also commonly issued by companies with low cyclicality, such as utilities and telecoms.

The vast majority of preferred issuers are investment-grade companies. And while preferreds ratings are typically three to five notches below those of the senior debt of the issuers due to their subordination, approximately two-thirds of preferred issues carry investment-grade ratings. The issuers’ strong balance sheets mean the potential for preferred defaults in a slowing economy is low.

EXHIBIT 5

Preferreds have diversifying correlations to other fixed income sources

Correlations of monthly returns

October 2012–November 2022

At November 30, 2022. Source: Morningstar, 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, and there is no way to predict precisely when such a trend will begin. An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes. This chart is for illustrative purposes only and is not intended to represent the returns of any specific security. Index comparisons have limitations as volatility and other characteristics may differ from a particular investment. Correlation coefficients are based on monthly data and measure the degree to which the returns of two assets move together. Correlations vary from –1.0 (perfect inverse relationship) to 1.0 (perfect synchronization). See end notes for index associations, definitions and additional disclosures.

Active managers can potentially capitalize on a changing interest rate environment

Active investment managers have tools to adjust a preferred portfolio’s interest- rate sensitivity depending on their market outlook. Interest-rate sensitivity is commonly measured by a security’s duration: the higher its duration, the more its price is likely to move up or down with changes in interest rates.

Approximately three-quarters of the $1.3 trillion global preferred market has a duration of five years or less, as many preferreds have terms whereby their coupons reset relative to a benchmark rate. For example, floating-rate securities reset every quarter, while others may reset after five or 10 years from the date of issuance at a spread over a benchmark rate, such as 5-year Treasuries.

When conditions warrant a defensive interest rate stance, such as today, managers can favor issues with high coupons, near-term resets and/or high coupon reset spreads, providing a greater cushion to absorb higher interest rates and wider credit spreads. Securities with short call dates (and thus low duration) also tend to be less interest rate sensitive and less volatile.

As the end of the rate-hiking cycle draws closer, active managers may favor securities with lower coupons or longer terms until coupons reset. And when the economy appears to be on the upswing again, they can increase allocations to preferreds with lower credit quality that may benefit more from an improving economy. Preferred managers may also invest in non-U.S. securities, including contingent capital securities (CoCos), which are issued chiefly by European banks and offer attractive income levels and total return potential.