Preferred Securities: Compelling Yields and Diversification in a Tough Income Market

Income-focused investors face a challenging investment environment. Years of low interest rates have constrained income potential across investment grade fixed income markets worldwide, with some sovereign debt even dipping into negative terrain. And with central banks taking a decidedly accommodative stance in response to the coronavirus pandemic, this backdrop shows no signs of shifting significantly anytime soon. The US Federal Reserve has indicated that it will target 2% inflation over time and accept some amount of overshoot, signaling that interest rates stay close to zero for the foreseeable future.

Such post-Covid policy shifts are once again prompting investors to expand their search for income beyond traditional bond markets as they pursue more compelling yields, stronger portfolio diversification, and better management of interest rate risk. Preferred securities have historically delivered on all three fronts by providing high relative income potential with historically low correlations and low durations compared with other fixed income segments.

What is a preferred security?

Today’s preferred security market is incredibly diverse and covers a wide range of securities, with companies often issuing more than one type. At their core, however, these investments, also known as “preferreds” and “hybrids,” represent non-voting ownership in a corporation, with fixed income features that make them similar to bond investments. Some subsegments in the category may be classified as debt holdings on corporate balance sheets and are convertible into equity when pre-specified events occur.

Preferreds offer a number of distinct attributes:

• Unique capital structure placement. Preferreds are senior to common equity and subordinate to corporate debt in cases of company liquidation. They are usually issued without voting rights and generally offer lower capital appreciation potential than common stock, though notable price gains can occur when interest rates decline or issuer credit fundamentals improve.

• Attractive levels of current income. Preferreds typically come with preset fixed, floating, or adjustable dividend targets (segments classified as bonds tend to pay interest rather than dividends, which can affect tax treatment). Unlike most bonds, however, issuers can defer or miss payments without triggering an event of default. While suspended payments have been extremely rare, preferred securities are typically issued with higher yields than company debt to help compensate for this risk, as well as their lower capital structure placement. Preferred securities are sometimes – though not always – issued with cumulative rights that require any arrears be paid before any future common stock payout. How this applies to multiple types of preferred securities from the same company can also be ranked in terms of priority.

• Issuance on a perpetual basis. Preferreds often do not have a maturity date, though they are generally structured as callable or convertible to common stock. New issuance is set at a par value, and once trading, price fluctuations are normally driven by interest rates and credit quality.

Preferred Securities May Offer Significant Income Advantages for Yield-Starved Investors

Yields to maturity for various fixed income segments

Source: Bloomberg Barclays, BofA, JPMorgan, Credit Suisse, and PineBridge Investments as of 31 July 2020. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Index proxies are as follows: US AT1 Preferreds–PineBridge US AT1 Index; EUR AT1 Preferreds–Bloomberg Barclays Contingent Capital USD Index; Legacy Preferreds–BofA Merrill Lynch Hybrid Preferred Securities Index; Preferred REIT–ICE BofA Preferred Securities Index; Euro Credit–Bloomberg Barclays Pan Euro Credit Index; Euro HY–Bloomberg Barclays Pan Euro High Yield Index; EM Corporate–JPMorgan CEMBI Broad Diversified Index; US Credit–Bloomberg Barclays US Credit Index; EM Hard Currency–JPMorgan EMBI Global Index; Bank Loans–S&P/LSTA Leveraged Loan Index; US HY–Bloomberg Barclays US Corporate High Yield Index; EM Local Currency–JPMorgan GBI-EM Global Diversified Index.

Due to regulatory and rating agency capital requirements, preferred securities tend to be issued primarily by financial institutions, such as banks, real estate investment trusts (REITs), insurance companies, and utilities. In fact, the financial services and utilities sectors make up nearly 90% of the ICE BofA Core Fixed Rate Preferred Securities Index. As the chart shows, this composition is almost a mirror opposite of the sector exposure in high yield bonds, where industrials make up nearly 90% of the market.1

Based on this sector footprint, preferred securities also tend to have higher credit quality relative to high yield bonds despite comparable yields, as they are issued by investment grade entities at the senior level. More than half the universe is investment grade, though a preferred security is typically rated below the issuer’s senior debt due to its subordination in the capital structure.2

Preferred Securities Can Help Diversify Portfolio Sector Holdings

Sector Exposure

Source: BofA and Bloomberg Barclays as of 31 July 2020. Preferred securities are represented by the ICE BofA Fixed Rate Preferred Securities Index; high yield is represented by the Bloomberg Barclays US Corporate High Yield Index. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

The preferred securities market has grown into a broad, highly liquid universe, at nearly $840 billion, with almost 61% issued in US dollars. Nearly 75% of preferreds globally trade in the over-the-counter (OTC) market, rather than on stock exchanges, and this portion continues to expand due to foreign issue growth and new security innovation.3

The pandemic regulatory response has been favorable for preferreds

Regulators in the US and Europe have taken various actions recently to facilitate market functioning amid the Covid-19 crisis, many of which have been positive for preferreds. In the US, regulators have modified leverage ratio calculations for banks to help ensure adequate liquidity in critical markets for US Treasuries and repurchase agreements (repos). Regulators have also eased or delayed other capital requirements and accounting rules in the US and Europe, helping ensure that common equity Tier 1 capital ratios, which provide buffers to preferred securities, remain high. In Europe, banks can now meet buffer requirements with an increased proportion of additional Tier-1 (AT1) securities. This has led to an increase in new issuance at attractive spreads.

The US and Europe have also established facilities to support liquidity for money market funds and commercial paper in response to the coronavirus pandemic. The Federal Reserve has created facilities spanning numerous asset classes to ensure that credit continues to flow and to keep default rates low (or prevent spikes due solely to a lack of liquidity). These programs include the Secondary Market Corporate Credit Facility and the Primary Market Corporate Credit Facility (both of which support investment grade credit markets and select “fallen angels”), as well as the Main Street Lending Facility and a program for municipalities, among others. In Europe, new targeted longer-term refinancing operations (TLTROs) have provided banks with sub-zero-cost funding to support lending. The Fed and the European Central Bank have also increased asset purchases through quantitative easing (QE) measures.

Banks have been a crucial conduit for implementing key fiscal programs as well, most notably the Paycheck Protection Program in the US. For banks, the cost of this fiscal and monetary support has been reductions in share repurchases and common equity dividends. That means banks are retaining more common equity, which again is positive for preferred security holders.

Building on the foundation of past reforms

These regulatory shifts follow earlier post-financial-crisis banking reforms. In 2010, the Basel III regulatory framework introduced requirements to help strengthen bank capital and liquidity, including an increase in minimum regulatory Tier 1 capital from 4% to 6% of risk-weighted assets, with at least 4.5% in common equity and 1.5% in AT1 securities.4

As the US Federal Reserve Board adopted these measures, it approved traditional callable, non-cumulative, non-step-up perpetual preferred securities as AT1s for banks under its jurisdiction. In contrast, many legacy preferred securities structures did not meet AT1 requirements. For example, trust preferred securities, which were largely issued by bank- or insurance-controlled trusts, were phased out of Tier 1 capital in the US. Banks responded by issuing sizable volumes of qualifying AT1 securities.

In Europe, regulation implementing Basel III led to the development of approved preferred securities known as contingent convertible securities, or “CoCo bonds,” for AT1 usage. These securities satisfied the new standards and sought to limit future bailouts by including explicit loss absorption provisions at specified trigger levels, either through principal write-downs or conversion to equity. Since adopting the structure, CoCo bonds have become a major component of the global AT1 market.

The first AT1 securities were issued in 2013, and the segment has since grown rapidly. While growth has slowed more recently, with refinancing of existing deals making up the bulk of new issuance, the expansion of the segment has provided investors with ample opportunities for diversification and alpha generation.

Additive investment characteristics

As the preferred securities market has expanded, its attractive mix of investment attributes has helped fuel increased investor interest.

• Strong returns. US and European AT1 and US REIT preferred securities have all significantly outperformed other fixed income investments since the implementation of Basel III. Annualized returns have been comparable to the S&P 500 Index with considerably less risk, as measured by standard deviation.5

• Low correlations. Preferred securities have also provided diversification benefits, not surprising considering their low correlations to other asset classes. As a group, the segment has had a low (0.01) correlation to US Treasuries. Correlations are in the 0.45 to 0.70 range for US investment grade corporate credits, US high yield bonds, bank loans, and US equities.6

• Less interest rate sensitivity. These return and correlation benefits relative to other higher-yielding asset classes become particularly relevant in rising-rate environments, as these asset classes are often used to help protect portfolio bond allocations against interest rate volatility. While preferred securities’ higher yields provide a degree of protection on their own, the bulk of the preferred securities market consists of fixed-to-floating-rate securities which pay a fixed coupon for a preset number of years – typically five to 10 – and then typically reset every five years at a spread versus Treasuries. This significantly lowers duration compared to fixed-for-life structures, helping to cushion prices when rates rise and increasing yield payouts.

• Low defaults. Despite their subordination, the segment’s historical annual impairment rate of 1.7% since 1980 remains well below the 4.4% default rate in US high yield bonds and closer to the 0.1% rate in US investment grade corporate credit.7

Many Preferred Securities Have Outperformed Other Fixed Income Segments

Annualized risk and return: January 2014 to July 2020

Source: Bloomberg Barclays, BofA, JPMorgan, S&P/LSTA, and PineBridge Investments as of 31 July 2020. Past performance is not indicative of future results. All returns 100% hedged to USD. Index proxies are as follows: US AT1–PineBridge US AT1 Index; European AT1–ML CoCo Index; Global AT1–50% US AT1/European AT1; Euro Credit–Bloomberg Barclays Pan Euro Credit Index; Euro HY–Bloomberg Barclays Pan Euro High Yield Index; EM Corp– JPMorgan CEMBI Broad Diversified Index; US Credit–Bloomberg Barclays US Credit Index; EM Hard Currency–JPMorgan EMBI Global Index; Bank Loans–S&P/LSTA Leveraged Loan Index; US HY–Bloomberg Barclays US Corporate High Yield Index; EM Local–JPMorgan GBI-EM Global Diversified Index. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the investment manager, are valid as of the date indicated, and are subject to change.

Taken together, these characteristics make the asset class an attractive component of a diversified portfolio strategy. While yield-hungry investors may initially be drawn to preferreds for their attractive income profile, the segment offers much more from a strategic allocation standpoint and is an effective way to enhance risk-adjusted return.

Attractive current yield spreads

From an opportunistic perspective, relative valuations are at attractive levels versus many other fixed income investments. Current yield spreads to US Treasuries and investment grade corporate credits are 90% and 410% higher than pre-crisis averages, respectively.8 Preferreds also remain more compelling than high yield bonds at this point in the cycle, in our opinion, due to the latter’s tighter spreads and potentially stretched balance sheets.

Preferred Securities May Offer Attractive Value Versus Long-Dated Treasuries and IG Credit

Fixed rate preferred spread over US Treasuries and US credit: January 1996 to July 2020

Source: Bloomberg Barclays, BofA, and PineBridge Investments as of 31 July 2020. Past performance is not indicative of future results. Index proxies are as follows: Fixed Rate Preferred–ICE BofA Fixed Rate Preferred Index; US Treasuries–Bloomberg Barclays US Treasury Index; US Credit–Bloomberg Barclays US Credit Index. Spread is the difference in yield to maturity. Pre-crisis average is from January 1996 through August 2008. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

Outlook and risk considerations

Our outlook for the preferred securities segment remains positive. Performance has continued to be strong, and favorable fundamentals and improving technicals should provide solid tailwinds for the foreseeable future.

Furthermore, US and European banks have been active issuers of AT1 securities and now have a relatively small shortfall to meet capital requirements. Although there will continue to be new primary issuance as legacy securities and older AT1s are called, we expect new supply to continue to moderate. This trend, coupled with expected rising demand from multi-asset managers and major institutional investors, such as pensions and insurance companies, signals continued supportive technicals for the segment.

Any substantive economic slowdown or extended risk-off investment climate could spark a selloff. Investors should weigh these types of considerations before they invest. Overall, however, we believe preferreds remain very appealing and expect the segment to outperform over the near- to intermediate-term.

Active management can be key

As more institutional investors have taken an interest in the asset class, the investment management industry has responded with a growing number of preferred securities offerings. Much of this has been in passively managed exchange-traded funds (ETFs). However, a high degree of variation across issue structures and relative fundamental credit differences among individual issuers have resulted in wide variations in returns. Proactively managing call and default risks can also have a significant impact on performance, offering active managers the potential to create alpha.

ETFs fail to tap into this potential, as detailed by the scatterplot of 36-month returns and volatilities for iShares Preferred & Income Securities ETF and its constituents. The main takeaway is the wide range of outcomes among these constituents, highlighting the opportunity for a proven active manager to add value to a client portfolio.

Passive Preferred ETFs Can’t Capitalize on Wide Return Variance

Preferred securities ETF and its constituents

Source: Bloomberg and PineBridge Investments as of 30 June 2020. Preferred Securities ETF is iShares Preferred & Income Securities ETF. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

The active managers best positioned to deliver outperformance will be those with time-tested track records. Traits to look for include:

• Experience in delivering repeatable alpha across market cycles while consistently avoiding defaults.

• Nimbleness in portfolio size – those with smaller, manageable assets are often able to take greater advantage of excess return potential in security selection and have the flexibility to act quickly during market dislocations.

• Proven research capabilities – ultimately, these remain credit-driven securities, and strong bottom-up, fundamental research can provide significant differentiated returns.

Selecting a skilled, dedicated active manager can help investors realize the full potential of the asset class, which continues to be overlooked by many investors. While more investors are adding preferred securities to portfolio allocations, there remains a general lack of awareness and understanding of the segment. We expect this will continue to change as investors are attracted to the favorable income profile, strong total returns, and diversification benefits of preferreds.

The current environment has highlighted the resilience of issuer fundamentals in this sector. We believe the unique characteristics offered by preferred securities should prove highly complementary for investors looking to better position their portfolios for stronger risk-adjusted performance in today’s market.

Access PDF