INSIGHTS

On May 05, 2017

Preferred Securities First Quarter 2017 Review and Outlook

Investment Review

Preferred securities rose in the first quarter, which was a positive period for most fixed income asset classes. Generally, credit spreads on fixed income securities, including preferreds, narrowed during the quarter as global economic data continued to improve.

Longer-term bond yields in the United States were relatively stable and ended the quarter only slightly lower than where they began, even though the Federal Reserve raised interest rates in March—its second rate hike in three months. The 10-year U.S. Treasury note traded between 2.32% and 2.62% and ended the quarter at 2.40%. Investors interpreted the economic projections that accompanied the Fed’s policy statement as being less hawkish than expected, even though more rate hikes are expected later this year. Additionally, Congress’s inability to repeal and replace the Affordable Care Act (“Obamacare”) made investors question the potential for substantial tax cuts and infrastructure spending plans—both of which were expected to spur near-term growth and put upward pressure on interest rates. European sovereign yields rose sharply in January on political concerns but declined through the remainder of the quarter along with the seemingly fading popularity of populist, anti-EU (European Union) politicians.

In this environment, preferred securities outperformed longer-dated Treasuries, investment-grade corporate bonds and high-yield bonds. Light issuance generally aided preferreds’ performance during the quarter as it helped maintain a favorable supply-demand dynamic. Expectations for easier bank regulation resulting in lighter capital needs under Trump may have resulted in a scaling back of bank preferred issuance plans. Within the preferreds market, exchange-listed issues outperformed over-the-counter (OTC) securities, a reversal from the fourth quarter when the OTC market benefited from having a greater prevalence of more defensive security structures relative to interest-rate risk.

Bank and insurance preferreds, which account for the majority of the preferreds market, mostly experienced positive total returns in the quarter. Preferreds of U.S. banks, which reported strong earnings in January, continued to benefit from favorable sentiment regarding their issuers’ improving financial profiles. The sector was also supported by signals from the Trump administration that strict bank regulations may be eased, as lighter regulation is generally seen as a positive for bank earnings. Insurance companies reported earnings in February that were generally favorable, although results from the property and casualty subsector were more mixed.

Certain higher-quality preferreds issued by Real Estate Investment Trusts (REITs) and utilities outperformed the larger preferreds market, as many of these issues have a higher sensitivity to stable or falling interest rates. Moreover, supply conditions tightened in REIT preferreds as companies continued to announce redemptions in favor of alternative, cheaper funding sources.

Investment Outlook

After years of disappointing growth, we expect the global economy to accelerate somewhat in 2017, supported in part by continued strength in the United States, as well as signs of improving growth in both Asia and Europe. A more stable U.S. dollar in recent months could also contribute to emerging markets growth. This backdrop may help central banks back away from supporting economies through unconventional monetary stimulus, although we expect tighter monetary policy steps, including U.S. interest-rate hikes, to be gradual in the interest of growth. The potential for large tax cuts and increased fiscal spending under the Trump administration has further lifted expectations for growth in the United States, but other policy statements have also raised questions around global trade and geopolitics. On balance, we expect the Trump effect to add to the growth and inflation trends that were already underway.

In the United States, policymakers are likely to continue to react to tight labor markets and gradually rising inflation, and we expect the Federal Reserve to raise rates again in the near term. However, depending on the path of rate hikes, this could lead to a flattening of the U.S. yield curve, with long-term rates rising much less dramatically if inflation expectations remain in check. While a flattening yield curve is a relatively normal occurrence during rate hike cycles, proposed tax reforms and other initiatives by the Trump Administration may introduce meaningful uncertainty around the path of growth and Fed rate hikes.  

We generally see fixed income assets continuing to be more vulnerable to rising yields over time, but believe preferreds remain well positioned relative to other areas of fixed income. Preferred securities have characteristics that could help mitigate potential headwinds associated with a rising interest-rate environment, as their high income rates and wide yield spreads relative to Treasuries and corporate bonds could help cushion the impact of rising rates over time.

Additionally, the primary issuers of preferreds—banks and insurance companies—could benefit from higher rates, lighter regulation and potential corporate tax cuts, which can bolster their earnings power, strengthen their credit fundamentals and lead to narrower yield spreads. President Trump’s plan to reduce the regulatory burden on financial companies could improve the underlying fundamentals of the financial sector in general, as regulation introduced after the financial crisis tightened lending standards and increased regulatory costs in many cases. There could also be positive follow-on impacts to the broader economy if lending conditions ease. While U.S. bank capital levels could decline somewhat over time from historically high levels, capital is likely to remain very strong and supportive for preferred investors, in our view.

CRN: 2017-0503-5949R

Opinions in this piece are those of Cohen & Steers and are not necessarily that of AAM.  

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.

Preferred securities may be rated below investment-grade or may be unrated. 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 or competitive industry conditions than higher-grade securities.

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. In these commentaries, we sometimes 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. No representation or warranty is made as to the efficacy of any particular strategy or fund or the actual returns that may be achieved.

The views and opinions in the preceding commentary are as of the date of publication and are subject to change. This material should not be relied upon as investment advice, does not constitute a recommendation to buy or sell a security or other investment and is not intended to predict or depict performance of any investment.