Preferred securities delivered strong returns in 2017, outperforming most other classes of fixed income, including US Treasuries, investment-grade bonds and high-yield debt, with bank-issued CoCos, or contingent convertible notes, leading returns for the preferred securities market. The year was defined by a broad-based acceleration in global growth – the broadest since the IMF began collecting data in 1980 – as well as subdued inflation, low interest rates and a high investor appetite for income. In this environment, US and European banks – the largest issuers of preferreds – enjoyed strong earnings growth, benefiting from higher net interest margins, as well as improved trading and investment banking income – all of which contributed to improving credit fundamentals.
‘Improving fundamentals and relative value boosting preferred securities outlook’
In a yield constrained market, preferred securities provided an attractive yield-to-maturity of 5.6%, far in excess of the traditional investment grade credit market. Relative to high yield debt, we believe the appeal of preferred securities has moved in favour of preferred securities. Historically, high yield instruments – which are usually a number of notches lower in terms of credit quality – have offered a yield pick-up of about 230bps over preferred securities, but this has fallen to approximately 60bps in the global clamour for yield.
While sitting lower down in the capital structure, we currently see minimal default risk for issuers of preferred securities. With much of the preferred market being issued by investment grade banks and insurance companies, balance sheets and business models have improved vastly since the recent financial crisis.
With the global economy poised for continued growth, the Federal Reserve and other central banks could have greater reasoning to hike interest rates faster than the market expects, especially if stronger growth results in higher inflation. We believe that banks and insurance companies will benefit in this environment, as higher rates typically bolster net interest margins. In this respect, we believe preferred securities remain well positioned for higher interest rates relative to other areas of fixed income. Preferreds’ high income rates and wide yield spreads relative to US Treasuries and corporate bonds could help to cushion the impact of rising rates over time. In addition, reset structures, which dominate the over the counter (OTC) preferred market, can offer low-duration investments.
REIT fundamentals favourable
We believe fundamentals for commercial real estate – another significant issuer of preferreds – are likely to remain strong, with improving demand for most types of real estate and generally modest property supply growth. This favourable combination has helped drive operating incomes and reduce REIT preferreds’ risk premiums. And while the net supply of REIT preferreds may remain positive in the coming quarters, given their attractiveness as a source of capital compared with equity, we expect demand to readily absorb it.
We remain somewhat defensive relative to interest-rate risk
Our outlook for continued economic growth, tight labour markets, the potential for stimulative government policies and less accommodative central banks could all put upward pressure on interest rates. We therefore remain focused on attractive income opportunities in securities that offer relatively high absolute yields, call protection, wide credit spreads and fixed-to-floating-rate and floating-rate structures, which we believe will generate favourable risk-adjusted returns.
Brian Cordes is a portfolio specialist at Cohen & Steers