William Scapell, CFA
Head of Fixed Income and Preferred SecuritiesMore by this author
Elaine Zaharis-Nikas, CFA
Senior Portfolio Manager, Fixed Income and Preferred SecuritiesMore by this author
19 minute read
With inflation peaking and recession looming, we anticipate a strong vintage year for fixed income—with declining rates potentially leading to outsized returns and high tax-advantaged income from preferred securities.
- The Fed’s rate-hiking cycle is drawing to a close
Five-year U.S. Treasury inflation breakevens and other indicators signal that inflation may decline sharply in 2023 and the Fed’s rate-hiking cycle could end by May. Typically, bond yields quickly start to move lower once rate hiking ends. This potentially sets the stage for strong total returns from preferreds, which currently feature yields of 7–8% from investment-grade securities.
- Issuers are in excellent financial shape
Although the threat of recession looms, banks are in a position of strength. Core capital ratios are nearly double the levels seen before the 2008 global financial crisis. In addition, growth in net interest margins is at the highest level since 1976, providing an added cushion to absorb potential loan losses and support preferred dividends.
- Preferreds can help improve portfolio risk/reward profiles
Many preferred securities pay qualified dividend income (QDI), taxed at just 20% for top earners (compared with 37% for interest 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, in addition to their attractive diversification characteristics.
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.
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 12.7%, on average, and a 7.6% 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.
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.
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%.
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.
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.
Preferreds have delivered double-digit returns in six out of seven years following a negative total return, according to Cohen & Steers.
Index definitions and important disclosures
An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes.
Preferred securities: ICE BofA Fixed Rate Preferred Securities Index (Credit quality: BBB) tracks the performance of fixed-rate U.S. dollar-denominated preferred securities issued in the U.S. domestic market. Investment-grade bonds: ICE BofA Corporate Master Index (Credit quality: A-) tracks the performance of U.S. dollar-denominated investment-grade corporate debt publicly issued in the U.S. domestic market. High-yield bonds: ICE BofA High Yield Master Index (Credit quality: B+) tracks the performance of U.S. dollar-denominated below-investment-grade corporate debt publicly issued in the U.S. domestic market. Municipal bonds: ICE BofA Municipal Master Index (Credit quality: A.A.-) tracks the performance of U.S. dollar-denominated investment-grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions, in the U.S. domestic market. Aggregate bonds (Exhibit 5): Bloomberg U.S. Aggregate Bond Index is a broad-market measure of the U.S. dollar-denominated investment-grade fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities, and commercial mortgage-backed securities. U.S. Treasuries: ICE BofA U.S. Treasury Index tracks the performance of U.S. dollar-denominated sovereign debt publicly issued by the U.S. government in its domestic market. 5-year U.S. Treasuries: The 5-year Treasury note is a debt obligation issued by the United States government that matures in 5 years. Treasury bonds are fully taxable at the federal level at the taxable interest income rate of 37%. U.S. stocks: S&P 500 Index is an unmanaged index of 500 large-capitalization stocks that is frequently used as a general measure of U.S. stock market performance.
Data quoted represents past performance, which is no guarantee of future results. This material is for informational purposes and reflects prevailing conditions and our judgment as of this date, which are subject to change. There is no guarantee that any market forecast set forth in this presentation will be realized. This material represents an assessment of the market environment at a specific point in time and should not be relied upon as investment advice, does not constitute a recommendation to buy or sell a security or other investment and is not intended to predict or depict performance of any investment. This material is not being provided in a fiduciary capacity and is not intended to recommend any investment policy or investment strategy or take into account the specific objectives or circumstances of any investor. We consider the information in this presentation to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of appropriateness for investment. Please consult with your investment, tax or legal professional regarding your individual circumstances prior to investing.
Risks of investing in preferred securities. An investment in a preferred strategy is subject to investment risk, including the possible loss of the entire principal amount that you invest. The value of these securities, like other investments, may move up or down, sometimes rapidly and unpredictably. Our preferred strategies 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. The strategies’ benchmarks do not contain below-investment-grade securities.
Duration Risk. Duration is a mathematical calculation of the average life of a fixed-income or preferred security that serves as a measure of the security’s price risk to changes in interest rates (or yields). Securities with longer durations tend to be more sensitive to interest-rate (or yield) changes than securities with shorter durations. Duration differs from maturity in that it considers potential changes to interest rates, and a security’s coupon payments, yield, price and par value and call features, in addition to the amount of time until the security matures. Various techniques may be used to shorten or lengthen the Fund’s duration. The duration of a security will be expected to change over time with changes in market factors and time to maturity.
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