Preferred securities have historically offered the highest yields in the investment-grade market, and are currently benefiting from scarcity related to global financial reform.
Finding value in an era of financial reform
Regulators in the U.S. and around the world are in the process of setting new definitions for what types of securities may qualify as Tier 1 capital. Certain types of preferred securities may lose their Tier 1 status, thereby no longer serving as a cost-efficient form of capital for their issuers. As this happens, we expect to see a wave of companies calling, buying back and tendering for the affected securities, some of which may trade at a discount to par. This activity may also present new opportunities in the U.S. and globally if new preferred securities (potentially with new formats) come to market to replace called issues.
Preferred securities’ income advantage
With bond yields at or near historic lows, investors are searching for alternative sources of income. Preferred securities can enhance a portfolio’s yield without significantly sacrificing its credit quality profile.
Accessing the full spectrum of preferred securities
As more investors turn to preferred securities for their higher yields, many are limiting their selections to ETFs or investment grade $25 par securities. We think a better approach is through an active manager with the skill and resources to utilize the entire preferred securities market, including:
- Below-investment-grade preferred securities. Meaningful opportunities may arise in an issuer whose credit rating has suffered. If we believe the market is mispricing the credit risk, we may seek to take advantage of the security’s higher yield. The issuer may also return to investment grade status as it rebuilds its capital and demonstrates sustained profitability.
- Over-the-counter (OTC) preferred securities. More than half of the U.S. preferred securities market consists of issues that are traded over-the-counter by institutional investors. Differences in the structure of OTC and exchange-traded securities can have important investment implications, including interest-rate sensitivity.
- Foreign preferred securities. Some non-U.S. companies only issue preferreds in the OTC market to avoid the filing requirements associated with U.S. exchange listings. In addition, many companies issue preferred securities denominated in non-U.S. currencies. As an institutional investor with operations in key cities around the world, Cohen & Steers may be able to invest in these securities.
The views and opinions are subject to change without notice and represents an assessment of the market environment at a specific point in time, should not be relied upon as legal, investment or tax advice and is not intended to predict or depict performance of any investment. We consider the information to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of suitability for investment. Investors should consult their own advisors with respect to their individual circumstances.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. There is no guarantee that a market forecast made in this commentary will be realized.
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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. We will often make comparisons of preferred securities to corporate bonds, municipal bonds and 10-Year Treasury bonds. 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. Municipal bonds are issued and backed by state and local governments and their agencies, and the interest from municipal securities is often free from both state and local income taxes. 10-Year Treasury bonds are issued by the U.S. government and are generally considered the safest of all bonds since they're backed by the full faith and credit of the U.S. government as to timely payment of principal and interest.
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. The benchmarks may not contain below-investment-grade securities.