What impending resets mean for preferred securities

 

Brian Cordes, CAIA

Head of Portfolio Specialist Group

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4 minute read

December 2023

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Upcoming call dates/dividend resets provide preferred securities with a potential catalyst in today’s uncertain market. Primarily issued by investment-grade-rated companies, preferred yields are currently in the 7–9% range. Most preferreds come with dividend-resetting structures, potentially leading to income growth for investors in the face of sustained interest rates. Additionally, many securities are selling at 10–20% discounts to par value. Given their historical trend of trading near par, these deep discounts present significant potential for capital appreciation for patient investors.

Transcript

Hi, I’m Brian Cordes, Head of the Portfolio Specialist Group at Cohen & Steers.

We believe preferred securities present a compelling total return opportunity in today’s market.

High-quality preferreds, primarily issued by investment-grade-rated companies, offer 7 to 9% yields, as of mid-November, 2023, which is considerably greater than what’s available from investment-grade corporate bonds.

Many preferreds are also selling at 10 to 20% discounts to par value. Historically, these securities trade near par, so the deep discounts represent significant capital appreciation potential for patient investors.

And there’s a sometimes overlooked aspect to preferreds, unavailable from most other fixed income categories, that makes them particularly compelling in today’s potentially “higher for longer” rate environment: their resetting dividends.

Over-the-counter preferreds, which represent roughly 80% of the preferreds universe, feature dividend reset structures, in contrast to exchange-traded preferred issues, which are primarily fixed rate in perpetuity.

More than 10% of the preferreds market will either reset or be called in the next 12 months. These securities typically were issued when short-term rates were significantly lower than they are today.

Given recent strength in the U.S. economy, Federal Reserve rate cuts are generally not anticipated before the second half of 2024. With preferreds’ periodic payment resets, just the passage of time (if we experience “higher for longer” rates) should lead to significant increases in income for investors if the securities are not called.

Here are a few real-life examples.

Most preferreds reset spreads are in the range of 250 to 400 basis points above a given benchmark.

Many reset over short rates, such as the secured overnight financing rate, or SOFR.

Others reset over longer benchmarks, such as 5-year U.S. Treasuries.

Typically, the nearer-dated fixed-to-reset securities are trading at more shallow discounts. In our view, this makes shorter-reset issues particularly attractive “paid-to-wait inflation-beaters” in the near term.

Of course, issuers have the right to redeem securities at par value at the reset date rather than increase the dividend. But with many shorter-reset securities currently trading at discounts to par, a redemption would only increase these securities’ total returns. And if a security is called, investors can then use the proceeds to invest in other issues that are most likely yielding more.

Income investors may be tempted to consider alternatives such as high-yield bonds and leveraged loans (also known as floating-rate loans). Both of these categories have been strong performers of late, in part because they, too, can offer lower interest rate sensitivity. Floating-rate instruments have benefited investors in a rising-rate environment.

But while high-yield bonds and leveraged loans offer greater pre-tax yields than preferreds, they are (as a market) substantially lower-quality investments. For instance, the high-yield market has a B+ average rating, described as “highly speculative” by the rating agencies. In contrast, preferreds are typically issued by investment-grade companies, and on average, possess a rating that is four to five notches higher than the high-yield market.

High-quality issues with resetting dividends are only part of the preferreds total return story, but they can offer comfort in an unsettled investment climate.

Thanks for watching.


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ABOUT THE AUTHORS
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Brian Cordes, CAIA, Senior Vice President, is the head of Cohen & Steers’ Portfolio Specialist Group, which represents the company’s investment teams in interactions with institutional and retail clients.

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