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)
At April 30, 2024. Source: Bloomberg, Cohen & Steers.
There is no guarantee that any historical trend illustrated above will be repeated in the future or any way to know in advance when such a trend might begin. Data includes securities that are being called but not yet redeemed. See endnotes for additional disclosures.
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)
At April 30, 2024. Source: Bloomberg, Cohen & Steers.
Total issuance of preferred securities and other capital securities in the exchange-traded market and the institutional (over-the-counter) market. There is no guarantee that any historical trend set forth in this presentation will be realized. See endnotes for additional disclosures.
New issuance has picked up, but most deals are occurring in the institutional OTC market.
Why active management matters
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.
(1) At April 30, 2024. Returns since the indexes’ inception. Institutional market index: ICE BofA U.S. Investment Grade Institutional Capital Securities Index. Exchange-traded market index: ICE BofA Core Fixed Rate Preferred Securities Index. An investor cannot invest directly in an index, and index performance does not reflect the deduction of any fees, expenses or taxes. See endnotes for index definitions and additional disclosures.
EXHIBIT 3
A broader investment universe may provide more yield and total return
Composition of the $1.1 trillion preferred securities market
At April 30, 2024. Source: Bloomberg, Cohen & Steers.
Data quoted represents past performance, which is no guarantee of future results. There is no guarantee that any historical trend illustrated above will be repeated in the future or any way to know in advance when such a trend might begin. Based on par values of approximately 1,646 capital securities and other deferrable debt instruments denominated in USD, EUR and GBP and issued in the major domestic and Eurobond markets. Generally, denomination size must be a minimum of $100 million if issued in the U.S. exchange-traded market, $150 million if issued in the U.S. institutional market, €200 million, or £200 million to qualify for inclusion in our universe. Mandatory convertible preferred securities are excluded, while exchange-traded senior debt securities are included. Numbers may not sum due to rounding. See endnotes for additional disclosures.
Working with Cohen & Steers
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.
For more information, please contact your Cohen & Steers representative or call 800 330 7348.
FURTHER READING
Five reasons to consider preferred securities if you own municipal bonds
With many investors feeling the sting of taxes, municipal bonds aren’t the only option for tax-advantaged income. Preferred securities currently offer among the highest after-tax yields in fixed income, regardless of tax bracket.
3 Reasons to own preferred securities today
We believe an exceptional buying opportunity for preferred securities may exist today.
Preferred securities call alert—$19.3 billion reinvestment opportunity
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.
Index definitions / important disclosures
Please consider the investment objectives, risks, charges and expenses of any Cohen & Steers fund carefully before investing. A summary prospectus and prospectus containing this and other information may be obtained by visiting cohenandsteers.com or by calling 800 330 7348. Please read the summary prospectus and prospectus carefully before investing.
Data quoted represents past performance, which is no guarantee of future results. The views and opinions presented in this document are as of the date of publication and are subject to change. There is no guarantee that any market forecast set forth in this document 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.
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Preferred securities: Exchange-traded: ICE BofA Fixed Rate Preferred Securities Index tracks the performance of fixed-rate U.S. dollar-denominated preferred securities issued in the U.S. domestic market. OTC: ICE BofA U.S. I.G. Institutional Capital Securities Index tracks the performance of USD-denominated investment-grade hybrid capital corporate and preferred securities publicly issued in the U.S. domestic market. CoCos: The Bloomberg Developed Market Contingent Capital Index includes hybrid capital securities in developed markets with explicit equity conversion or write-down loss-absorption mechanisms that are based on an issuer’s regulatory capital ratio or other explicit solvency- based triggers.
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.
Risks of investing in preferred securities. Investing in any market exposes investors to risks. In general, the risks of investing in preferred securities are similar to those of investing in bonds, including credit risk and interest-rate risk. As nearly all preferred securities have issuer call options, call risk and reinvestment risk are also important considerations. In addition, investors face equity-like risks, such as deferral or omission of distributions, subordination to bonds and other more senior debt, and higher corporate governance risks with limited voting rights. Risks associated with preferred securities differ from risks inherent with other investments. In particular, in the event of bankruptcy, a company’s preferred securities are senior to common stock but subordinated to all other types of corporate debt.It is important to note that corporate bonds sit higher in the capital structure than preferred securities and therefore, in the event of bankruptcy, will be senior to the preferred securities. Preferred funds 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.
Contingent capital securities (CoCos). CoCos are debt or preferred securities with loss-absorption characteristics built into the terms of the security, for example a mandatory conversion into common stock of the issuer under certain circumstances, such as the issuer’s capital ratio falling below a certain level. Since the common stock of the issuer may not pay a dividend, investors in these instruments could experience a reduced income rate, potentially to zero, and conversion would deepen the subordination of the investor, hence worsening the investor’s standing in a bankruptcy. Some CoCos provide for a reduction in the value or principal amount of the security under such circumstances. In addition, most CoCos are considered to be high yield securities and are therefore subject to the risks of investing in 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.
Cohen & Steers Capital Management, Inc. (Cohen & Steers) is a registered investment advisory firm that provides investment management services to corporate retirement, public and union retirement plans, endowments, foundations and mutual funds. Cohen & Steers U.S. registered open-end funds are distributed by Cohen & Steers Securities, LLC, and are only available to U.S. residents.