INSIGHTS

On August 04, 2017

Preferred Securities: Second Quarter 2017 Review and Outlook

Investment Review

Fixed income assets produced positive returns in the second quarter, led by high-quality, long-duration securities, which outperformed shorter-duration issues as investors re-calibrated their expectations for inflation and central bank rate hikes. Preferred securities outperformed high-yield and investment-grade bonds, but trailed long-dated U.S. Treasuries.

Data continued to point toward a strengthening global economy, as U.S. growth picked up following a relatively slow first quarter, although the figures were somewhat weaker than expected throughout the quarter. Growth in Europe continued to strengthen in the quarter as well, while political uncertainty on the continent eased considerably with the victory of pro-euro candidates in Dutch and French elections, further bolstering the region’s outlook. In Asia, Japan’s government upgraded its assessment of the economy for the first time since December, citing stronger private consumption and an improved employment picture.

Even as growth appeared to accelerate, long-term interest rates declined as inflation remained subdued. In the U.S., the so-called “reflation trade” of expected faster growth and higher inflation that accompanied President Donald Trump’s election in November all but disappeared in the second quarter as anticipated tax cuts and infrastructure spending failed to materialize and inflation data softened. Crude oil prices fell, further tempering the outlook for inflation.

The 10-year U.S. Treasury yield declined from 2.4% to 2.3%. Despite benign inflation readings, in response to falling unemployment and the potential for wage inflation, the U.S. Federal Reserve raised its benchmark short-term interest rate by a quarter point in June, the third such increase since December 2016. As a result, the yield curve flattened, with the spread between 30-year and 5-year Treasury yields in late June reaching its lowest level since 2007. Inflation forecasts in Europe (with the exception of the U.K.) turned lower as well, as consumer inflation in the Eurozone slipped to 1.3 percent year-over-year. European bond yields were also impacted by political uncertainty.

Among preferreds, European bank contingent capital (CoCo) securities produced particularly strong returns. CoCos underperformed ahead of the French election, then outperformed significantly following the first-round voting, as risk premiums generally came out of European assets following the success of a pro-EU candidate.

Another significant event in the quarter was the results of the U.S. Federal Reserve’s annual supervisory bank stress tests near the end of June. For the first time, all 34 participating U.S. bank holding companies passed, maintaining adequate common equity Tier 1 capital ratios in the most severe hypothetical stress scenario. The news was favorable for common equity shareholders, as passing the test provides banks with more leeway to return capital to shareholders in the form of increased dividend payouts and share buybacks after years of building capital well-in-excess of requirements. Somewhat less stringent regulation is widely viewed as a positive for the banks, signaling positive earnings growth potential.

In a trend that has persisted throughout 2017, investor inflows into preferred exchange traded funds (ETFs) resulted in indiscriminant buying in certain exchange-listed securities with both shorter and longer durations. The benchmark-following ETFs were forced to purchase securities that included some trading at substantial premiums to par value, even though in many cases the securities may be called at any time at par.

Investment Outlook

We expect positive global economic growth conditions to persist through the second half of the year, with improving employment and rising personal incomes likely to spur consumer spending and business investment alike. We expect inflation to remain in check for now, due in part to moderating energy prices. Nonetheless, we expect the U.S. Federal Reserve (Fed) to continue to tighten monetary policy at a gradual pace and to include the beginning of a reduction in the size of the Fed balance sheet.  

In addition to a positive macroeconomic backdrop, we expect a number of favorable market drivers to persist for the preferred securities market. Most notably, bank and insurance industry fundamentals appear strong and improving. Loosening bank regulatory conditions are typically supportive for corporate earnings and so far have had only a modest impact on credit. While U.S. bank capital levels could decline from historically high levels, we believe capital is nevertheless likely to remain very strong and supportive for preferred investors.

With the sharp decline in long-term interest rates in recent months, yields could rise modestly in the near term. Rates could be further pressured by the growth outlook, tight labor markets, current government policies and less-accommodative central banks. With respect to central banks, the beginning of the Fed’s balance sheet reduction could be a risk to credit markets, but we anticipate that the central bank will proceed cautiously. The European Central Bank (ECB) is expected to become less accommodative as well, as we see European economic prospects as sound, although still tempered by political risks, mostly attributable to Italy and BREXIT. Even though European inflation may take time to normalize, a discussion or actual tapering of the ECB’s quantitative easing program could affect global interest rates. Renewed optimism surrounding President Trump’s legislative agenda could also prove to be a risk for the bond market that may push interest rates higher.

Preferred securities remain well positioned relative to other areas of fixed income, in our view. Their high income rates and wide yield-spreads relative to U.S. Treasuries and corporate bonds could help to cushion the impact of rising rates over time. Over the medium to longer term, we believe banks and insurance companies, which are the primary issuers of preferred securities, may benefit from a rising-interest-rate environment, as higher rates could potentially bolster their net interest margins.

From a longer-term perspective, we continue to view fixed income assets as being vulnerable to rising yields. We therefore are focused on attractive income opportunities in securities that offer solid absolute yields, call protection and wide credit spreads, which we believe will provide favorable risk-adjusted returns. We believe securities with material call protection, including both fixed-to-float and fixed-rate preferreds, will outperform should rates remain low. If a large, unexpected spike in interest rates occurs, the lower duration of fixed-to-floating rate preferreds would likely help relative performance.

CRN: 2017-0803-6080 R

Data represents past performance, which is no guarantee of future results.

The views and opinions in the preceding commentary are as of the date of publication and are subject to change. There is no guarantee that any market forecast set forth in this presentation will be realized. The preceding commentary does not reflect the performance of any fund or account managed or serviced by Cohen & Steers and there is no guarantee that investors will experience the type of performance reflected in this commentary. 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. This material represents an assessment of the market environment at a specific point in time, and is not intended to predict or depict performance of any investment. We consider the information in this commentary to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of suitability for investment.

The preceding commentary is provided for informational purposes only. It is not an offer to buy or sell any product or service. Opinions in this piece are those of Cohen & Steers and are not necessarily that of AAM.

The preceding commentary is provided for information purposes only and does not pertain to any fixed income security product or service and is not an offer or solicitation of an offer to buy or sell any product or service. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and sustainability specifications. All expressions of opinions are subject to change without notice.

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.

Contingent capital securities (sometimes referred to as "CoCos") are debt or preferred securities with loss absorption characteristics built into the terms of the security, for example a mandatory conversion into common stock of the issuer under certain circumstances, such as the issuer's capital ratio falling below a certain level. Since the common stock of the issuer may not pay a dividend, investors in these instruments could experience a reduced income rate, potentially to zero, and conversion would deepen the subordination of the investor, hence worsening the investor's standing in a bankruptcy. Some CoCos provide for a reduction in the value or principal amount of the security under such circumstances. In addition, most CoCos are considered to be high yield or "junk" securities and are therefore subject to the risks of investing in below investment-grade securities.

All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at https://www.aamlive.com/legal/commentaries-disclosures.

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