Unlocking value: What end of rate hikes may mean for preferreds

Unlocking value: What end of rate hikes may mean for preferreds

William Scapell, CFA

Head of Fixed Income and Preferred Securities

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Elaine Zaharis-Nikas, CFA

Senior Portfolio Manager, Fixed Income and Preferred Securities

More by this author

19 minute read

December 2022

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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.

KEY TAKEAWAYS

  • 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.

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

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

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.

EXHIBIT 2
Preferreds typically have strong performance following rate-hiking cycles

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

January 1990–November 2022

Preferreds typically have strong performance following rate-hiking cycles

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

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

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 (%)

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

Preferreds have diversifying correlations to other fixed income sources

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.

ABOUT THE AUTHORS
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William Scapell, CFA, Executive Vice President, is Head of Fixed Income and Preferred Securities and a senior portfolio manager for the firm’s preferred securities portfolios.

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Elaine Zaharis-Nikas, CFA, CFA, Senior Vice President, is a senior portfolio manager for fixed income and preferred securities portfolios and has analyst coverage responsibilities for European and Latin American banks.

FURTHER READING

Institutional Investor: How the end of rate hikes could set the stage for preferred securities

January 2023 | 1 min

Preferreds have delivered double-digit returns in six out of seven years following a negative total return, according to Cohen & Steers.

3 reasons to consider preferreds when rates are rising

September 2022 | 10 mins

Preferred securities have characteristics that can potentially help mitigate the effects of rising interest rates.

Recession or not, growth is slowing: Our macro team’s view

August 2022 | 10 mins

Our base case calls for a shallow recession as inflation peaks and central bank policies take hold. Here’s how we’re positioned across key strategies.

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