What recent call and issuance activity say about preferreds

What recent call and issuance activity say about preferreds

12 minute read

May 2024

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An evolving market presents risks as well as opportunities for investors in exchange-traded preferred securities.

KEY TAKEAWAYS

  • Redemptions and new issuance have been strong this year, with issuers increasingly turning to the OTC market, where liquidity is greater and credit spreads more attractive.
  • Tighter supply in the $25 par market is supportive of prices but presents reinvestment challenges for financial advisors and investors.
  • Active managers have a broader opportunity set with the higher-yielding institutional market and an ability to strategically and tactically position a portfolio, a benefit unavailable from passive ETFs.

The $25 par preferreds market continues to contract

New issuance of preferred securities is off to a strong start in 2024, totaling $48 billion through April, on pace to far surpass the $70–75 billion in redemptions in each of the past two years. Issuance has picked up as credit spreads have tightened. Additionally, many fixed-to-reset preferreds’ coupons reset to 8–9.5% (300–400 basis points over the Secured Overnight Financing Rate [SOFR]), so some issuers have replaced these securities with new ones yielding around 7–7.5%, with far lower resets. Although issuance has been relatively heavy, market technicals have remained supportive, as issuers have redeemed $51 billion of preferreds this year for a net decrease of $3 billion (Exhibit 1).

Moreover, the exchange-traded ($25 par securities) portion of the market continues to meaningfully shrink. Issuance of $25 par securities has been minimal at just $2.4 billion this year, while companies have redeemed $6.7 billion (or about 4% of all exchange-traded preferreds), resulting in a $4.3 billion contraction in the market. This comes on the heels of $3.7 billion in net redemptions in 2023.

What’s behind the net redemptions? Some issuers have called securities without replacing them following balance sheet improvements; others have elected to refinance in the over-the-counter (OTC) market because of pricing and liquidity considerations.

EXHIBIT 1
Issuers are migrating to the OTC market

Preferred securities market activity in 2024 ($ billions)

Issuers are migrating to the OTC market

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Tighter supply is supportive of prices but presents reinvestment challenges

Net redemptions in $25 par securities have contributed to tighter credit spreads and supported the preferreds market’s positive returns in recent months (despite rising interest rates).

Preferred securities investors concentrated in the exchange-traded market— either through single issues or through passive ETFs (which tend to invest exclusively in the $25 par market)—can continue to clip attractive coupons. However, they risk losing value if the securities they own are called when trading above par. And they may be forced to reinvest into other $25 par securities trading with relatively tight (unattractive) credit spreads in a shrinking market.

Alternatively, investors may want to turn to an actively managed preferred securities mutual fund that invests in both the exchange-traded and the OTC market. Such funds can attempt to avoid holding securities likely to be called at unfavorable prices, and they can attempt to manage reinvestment risks. We believe this is the smart choice, as OTC credit spreads are generally more attractive, new issuance opportunities are more robust, and yields are much higher, providing greater compensation against rising risk-free rates and senior debt yields.

Within the OTC market, issuers have also been refinancing higher-yielding preferreds. But in contrast to the exchange-traded market, there has been $10 billion of issuance, net of redemptions, in OTC preferreds. The OTC market is growing and is now 84% of the global preferreds market, up from 77% in 2012. As with $25 par securities, credit spreads in the OTC market have tightened, but the broader investment universe has provided a larger opportunity set to manage reinvestment risks. OTC investors can access securities with attractive yields and call protection that represent potentially good investments for the medium to longer term.

EXHIBIT 2
Low new issuance poses a reinvestment challenge

Total preferred securities issuance by calendar year ($ billions)

Low new issuance poses a reinvestment challenge

We believe navigating the preferreds market requires active management, deep securities research and the ability to build diversified portfolios across the preferreds universe. Preferreds are offered in two markets: $25 par securities traded on the New York Stock Exchange and $1,000 par OTC-traded issues typically reserved for institutional investors. OTC securities now make up 84% of the $1.1 trillion global preferreds market (Exhibit 3).

The exchange-traded market has shrunk to just 16% of the overall preferreds market (down from 23% in 2012) as more companies choose to issue securities in the OTC market. Growth in the OTC market is also being driven by foreign issuers and the development of relatively new types of preferred securities— such as contingent capital securities (CoCos), which provide some of the highest yields among global fixed income securities and are issued exclusively in the OTC market.

Active fund managers typically build portfolios consisting of securities from both the $25 par market and the institutional market, offering the potential for:

  • Better returns: The OTC market has outperformed the $25 par market by 1.7% annually since 1997.(1)
  • Higher yields: Certain types of securities and geographies may offer above- average income rates.
  • Reduced interest rate sensitivity: While most $25 par securities have fixed-rate coupons, nearly all securities traded in the OTC market feature rate resets, often resulting in low durations.

Active managers can employ preferred securities in a variety of ways to generate alpha and seek to limit risk—advantages not available to investors in single-issue preferreds or passive preferred exchange-traded funds.

Yield and credit quality:
EXHIBIT 3
A broader investment universe may provide more yield and total return

Composition of the $1.1 trillion preferred securities market

A broader investment universe may provide more yield and total return

While the preferreds asset class is complex, investors who choose to work with a dedicated specialist manager, well versed in navigating preferreds markets, can achieve rewarding results. It is our view that research-driven active management, together with a global reach, is the best formula for pursuing desired outcomes.

Cohen & Steers’ five portfolio managers have an average of 22 years of experience and have full access to the global preferreds market. They are backed by a team of four analysts whose proprietary research is supported by extensive contacts in the industry. The group also leverages the global research capabilities of Cohen & Steers’ real estate and real assets investment professionals.

Cohen & Steers’ actively managed preferred securities open-end mutual funds

FURTHER READING

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Preferred securities call alert – $10.7 billion reinvestment opportunity

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Investors are facing new challenges as many of their single-issued preferred securities may be subject to call—including some that are trading above par and could lose value. Now may be the time to look beyond single issues to the added value of an actively managed portfolio.

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