By Brian Cordes
Years of low bond yields have driven many investors to look for new ways to get the income they need. One area of the market getting increasing attention is preferred securities.
At a time when 10-year Treasurys are yielding less than 2.5 percent, preferreds are paying more than five percent. That’s nearly as much as junk bonds, even though most preferreds carry investment-grade ratings.
Preferreds also have a strong track record of total returns, widely outperforming investment-grade bonds over the five years ended September 2017 and modestly outperforming high yield debt, but with significantly less volatility.
Considered a form of equity, preferreds act more like bonds, paying a fixed or floating coupon and having a set face value, with prices that move up and down based on changes in interest rates and credit factors rather than earnings.
Unlike bonds, coupon payments are discretionary and are often noncumulative, meaning that missed coupons aren’t paid back. In practice, though, it is extremely rare for preferred payments to be deferred or omitted, since it can affect a company’s ability to raise capital in the future. In the event of a company’s liquidation, preferred shareholders have to wait behind bondholders to claim corporate assets. Many preferreds also have call provisions, which allow the issuer to redeem the security at par after five or 10 years.
In return, preferreds tend to pay higher yields than what investors could normally earn with similarly rated bonds. Even so, most investors want a high degree of confidence that coupon payments will be made. As a consequence, you won’t see many preferreds from issuers with volatile or cyclical income.
Preferreds are issued primarily by banks, insurance companies, utilities and real estate investment trusts known as REITs—highly regulated institutions with relatively stable cash flows. This is different than what you typically see in traditional bond investments. For example, unlike in the high yield market, the preferred market has almost no exposure to energy companies.
Differences in preferred risk factors and sector concentrations relative to other fixed income markets have historically resulted in low correlations with many asset classes, making preferreds an effective complement to high yield and traditional investment-grade bond markets.
According to our analysis, adding preferred securities to a diversified fixed income allocation would have improved overall returns over the past five years while helping to contain volatility, resulting in a more efficient portfolio.
We believe the future remains bright for preferred securities, as the market continues to benefit from favorable regulatory tailwinds. Stricter regulations in the wake of the financial crisis have forced banks and insurance companies around the world to strengthen their balance sheets and improve their capital quality. In turn, stronger credit fundamentals have bolstered preferred securities prices. This trend of raising equity capital through the preferred market is expected to continue, particularly in Europe, where most banks are still working to achieve required regulatory capital levels.
As far as interest-rate risk, preferreds come in many types of structures, which can affect a security’s sensitivity to changes in interest rates, measured in years of duration. Some fixed-rate preferreds may have high durations, while there are others with fixed-to-float or pure floating-rate structures that may have relatively modest durations. Many of these low-duration securities are found in the institutional over-the-counter preferred market, which is roughly four times the size of the retail exchange-listed market.
Today, more than 60 percent of the overall global preferreds universe has a duration of less than five years. This provides active fund managers the opportunity to manage a portfolio’s interest-rate sensitivity by concentrating assets in securities with different structures and durations.
We believe preferred securities’ unique combination of high income rates, largely investment-grade issuers, distinct sector exposures and differences in security structures make them an attractive complement to fixed income allocations. Yet they remain largely under-represented in high-net-worth and institutional portfolios, falling outside the typical range of what investors contemplate.
Considering the complexities facing fixed income investors today, it may be time to take another look at this compelling category.
Brian Cordes, is a Senior Vice President & Portfolio Specialist at Cohen & Steers.