In the worst year for preferred securities since the financial crisis, we are finding value in almost every corner of this global market. With the 10-Year Treasury yielding under 3%, investment-grade preferreds are paying 6.1% on average, providing generous compensation by historical standards amid a backdrop of healthy fundamentals for most preferred issuers.
Looking at the market's violent swings in the fourth quarter, investors might think the wheels of the economy are coming off. Concerns about growth, politics and Federal Reserve policy have prompted investors to sell riskier assets across the board, helping to drive credit spreads sharply wider.
The recent decline has been especially unsettling for investors in preferred securities, where returns have been positive every year since 2009 (Exhibit 1). This year, by contrast, total returns have been negative despite the high income preferreds generate, as security prices have fallen 8-10%. While there are still questions to sort through, we believe a great deal of negative news is already priced in. That could mean an attractive opportunity for investors able to look through volatility in the short run.
To understand why, let's start with some context around what's causing the selloff in preferreds.
Slowing growth prospects. US corporate earnings accelerated rapidly in 2018, boosted by unusual late-cycle tax cuts and easing regulations. Those effects are starting to wear off just as the trade war between the US and China appears to be heating up, and as the Federal Reserve has reached a later, more dangerous stage of its tightening cycle. Together with signs of a broader global growth hiccup and various political uncertainties, such as Brexit, risk assets have been pressured.
Preferreds have been particularly affected by investors' reduced appetite for risk, sensitive to both widening credit spreads and rising subordination premiums (the additional yield investors demand for being behind senior debtholders in line to recover assets in the event of an issuer's bankruptcy). The fact that the largest issuers of preferreds are financials could also be playing a role in volatility, with slowing growth potentially impacting loan losses.
While softer economic growth could mean wider credit spreads, it does not necessarily mean there will be a spike in bankruptcies, or that bad loans and investments will significantly impact the large banks and insurance companies that issue preferreds. These companies have spent years raising capital and are much healthier than before the financial crisis, which we believe has better prepared them to withstand even a serious downturn. Bank regulators in the US and Europe have said as much, giving passing grades to every one of the large banks they assessed in these regions, using harsh stress tests that assume dire economic scenarios.
The bigger question may be whether the Fed can successfully orchestrate a soft landing, tempering its path of rate hikes before the economy teeters into recession. Considering that financial conditions have already tightened amid widening credit spreads and a shrinking Fed balance sheet, we believe the Fed could pause its rate hikes at or below 3% without risking economic overheating.
Year-end technical pressures. Negative sentiment surrounding preferreds has been amplified by a mass exodus from exchange-traded funds (ETFs) and mutual funds that have large investments in preferreds. These redemptions have resulted in indiscriminate selling, including in the $25-par retail preferred market, accelerating the decline in preferred securities prices.
We believe a significant factor in the outflows is late-year taxloss selling in the first down year for preferreds in a decade. As well, many non-dedicated credit funds tend to be "tourists" in preferred securities in good markets—taking advantage of high income and historically strong total returns—but turning into sellers amid market weakness. In some cases, they may sell ahead of year end to protect performance or for balance sheet presentation. At the same time, market makers tend to take less risk at year end, often leading to exacerbated price moves amid lower liquidity. These activities mean that the turn of the calendar could be a factor, as we believe some pressures could abate on January 1.
Brexit uncertainty. With time running out before the March 29, 2019 Brexit deadline, tense domestic politics have raised doubts about whether the UK Parliament will approve the transition agreement with the European Union. The outcome could have major economic consequences, and many investors are taking a cautious approach amid a highly fluid situation.
We expect markets could remain volatile in the near term. But the preferreds of many high-quality European companies now yield 7-9%, reflecting dire scenarios that we believe are very unlikely. The major UK and European banks are well capitalized in response to stricter regulations following the financial crisis, and even a hard Brexit shouldn't have dire consequences, in our view.
Company-specific issues. A ratings downgrade of GE senior debt to below the single-A category, along with questions about certain utilities affected by the California wildfires, has added to the declines in the preferreds market. To be sure, these are complex situations that require active management. However, we have found select investment opportunities in these situations that we believe are very attractive.
Three reasons to own preferreds now
1. Material value relative to risk. The price pressures across the preferreds market have been severe, generally more so than we believe is warranted based on the underlying risk factors. This does not mean we are taking more risk in portfolios, but rather that we see good value for term investors.
We expect credit spreads to remain volatile in coming months, and therefore we remain more defensively postured relative to credit risk in our portfolios (see sidebar below).
But so long as the economy does not experience a severe contraction in growth, leading to a material rise in bankruptcies, we believe current spreads represent good value.
The factors driving volatility may continue into 2019, in our view, as trade, Fed policy and other political events, such as Brexit, could have a meaningful impact on sentiment in the near term. But over the course of the coming year, we believe prices are likely to recover somewhat due to strong corporate fundamentals. And if Treasury yields stay low as a result of softer economic growth, that could once again attract income buyers to preferred securities. Going back to 1990, there has been only one instance in which preferred securities delivered negative returns two years in a row: the financial crisis of 2007-2008. We believe this consistent track record owes in large part to preferreds' high and steady income.
2. High income. An index of high-quality, investment-grade preferreds currently offers income rates of 6.1%, while many European and below-investment-grade issues offer 7-9% yields. In our view, these yields are attractive when compared with other investment-grade fixed income classes (Exhibit 3). With the 10-Year Treasury yielding 2.9% as of December 11, 2018, that represents an average spread of 329 basis points, which is generous on a historical basis, particularly relative to the pre-crisis average of 225 basis points (see Exhibit 2 above).
3. Potential diversification with other fixed income categories. Although preferreds are often compared with high yield bonds due to their high-income characteristics, investors should note their drastic differences. High yield markets tend to have a high concentration in cyclical sectors such as energy and basic materials. By contrast, preferreds are typically issued by companies in highly regulated industries and in sectors featuring relatively stable cash flows, such as utilities and REITs. High yield securities tend to compensate investors for high leverage, cyclicality, small operating footprints, short operating histories and other such risks, whereas preferreds compensate for subordination and dividend risks within what are generally large investment-grade issuers.
Recent volatility in the preferreds market has been a harsh reminder that although these securities are mostly rated investment grade, they are not without risk and can see meaningful price swings at times. However, short-term fluctuations may not always accurately reflect the state of underlying fundamentals. We believe this is generally the case today.
Considering the meaningful risk currently reflected in prices, as well as high income rates and diversification potential, we believe preferreds may be positioned for a strong year in 2019.
Bill Scapell is head of Fixed Income and Preferred Securities at Cohen & Steers