INSIGHTS

On April 17, 2023

AAM Viewpoints — Recent Bank Weakness Implications for Preferred Securities

Preferreds can offer long-term return potential superior to investment-grade and comparable to high-yield bonds, with diversification and quality advantages.

KEY TAKEAWAYS

• We believe financial regulators' recent aggressive efforts should instill confidence in the banking sector and prevent future bank runs.
• Excess liquidity in the banking sector can be supportive of preferred securities' dividends.
• Preferreds are attractive now, having repriced and with the rate-hiking cycle nearing an end, in our view.

Unprecedented moves to stabilize the banking sector

Preferred securities suffered steep losses in March as U.S. regional banks faced liquidity challenges amid greater-than-expected deposit outflows. The sudden collapse of Silicon Valley Bank (SVB) and Signature Bank raised concerns about contagion risks in the banking sector — the predominant issuer of preferred securities. SVB and Signature Bank represent the second- and third-largest banking collapses in U.S. history. The banks had a preponderance of large — and uninsured — deposits and/or significant unrealized losses on their securities portfolios. Ultimately, these banks faced greater-than-expected outflows which exceeded available liquidity, forcing regulators to intervene. While recent events have brought certain regional banks with similar risk exposures under scrutiny, the banking sector overall remains fundamentally healthy and adequately capitalized, in our view.

Financial regulators announced significant, aggressive actions intended to stem contagion risks across the banking industry. The FDIC (Federal Deposit Insurance Corporation) said it would fully guarantee depositors in the failed banks, even above the normal $250,000 threshold. In addition, the Federal Reserve (Fed) established an emergency loan program, accepting as collateral Treasury bonds at par value — even if the securities have been marked down. The Fed and other central banks also took steps to ensure U.S. dollars would remain readily available in the global banking system. And at the behest of regulators, Wall Street banks — flush with cash that depositors withdrew from smaller banks — funneled $30 billion into struggling First Republic Bank.

Excess liquidity in banking sector supportive of preferred dividends

We believe it is important to distinguish between SVB and the broader U.S. banking industry. Other banks may face possible liquidity challenges and forced selling of their assets, but we believe challenges with SVB and Signature Bank were largely idiosyncratic. SVB's and Signature Bank's deposits were large and predominantly uninsured. Further, SVB was concentrated across tech-related industries that experienced faster-than-expected cash burn rates as monetary policy tightened. The recent liquidation of Silvergate Bank, another bank focused on tech industries (notably the crypto market), further eroded market confidence in banks with significant tech exposure.

Deposits and overall funding are much more diversified across the broader U.S. banking industry. Smaller FDIC-insured retail deposits account for most of the industry’s deposits, in contrast to SVB's concentrated deposit base. Retail deposits are stickier, and we believe a more resilient funding source across the banking industry. The largest U.S. banks are also heavily regulated and typically exceed capital minimums and liquidity coverage ratios. Furthermore, larger U.S. banks have benefited from more diversified business models.

In contrast to the global financial crisis (GFC), banks are not plagued with bad debt, meaningful loan losses tied to housing, etc. Bad debt in this environment is low; the concern is about nervous depositors and a swiftly moving yield curve that can result in a mismatch between assets and liabilities in the event of significant deposit outflows. We expect to see regulatory enhancements targeting the treatment of regional bank balance sheets in the future, which will likely enact similar requirements to those that already exist for Global Systemically Important Banks.

Meanwhile, bank preferred dividends appear to be safe. The banking system has undergone a “crisis of confidence.” It is in banks’ best interests to restore this confidence rather than signaling further distress by suspending preferred dividend payments. For historical context, during the GFC, regulators asked banks to pay $0.01 in dividends to common shareholders so as to allow for continued payment to preferred shareholders to maintain confidence. Preferred securities went on to post strong total returns in 2009–2010.

Preferred securities remain an attractive investment

After last year’s interest rate-driven declines, we believe many fixed income investments represent a compelling opportunity for investors. Inflation, while sticky, is on the decline after peaking last October. And while the Fed may raise rates further, given recent events, we could see a slower path of rate hikes and perhaps a lower terminal rate. With the rate-hiking cycle likely drawing to a close, the stage is set for potentially strong total returns in fixed income markets, based on historical experience (Exhibit 1).

We believe preferred securities have great appeal for term fixed income allocations. Preferreds can offer both quality (most of the market is investment grade) and high income potential, typically well above that offered by investment-grade bonds (with tax advantages for U.S. investors). These characteristics have supported their strong total returns over time. Preferreds may also offer diversification benefits, with low correlations to other fixed income assets and exposure to less-cyclical businesses.

Investment-grade U.S. dollar preferred securities have historically exhibited resiliency in periods following market corrections and have performed remarkably well following the end of Fed rate-hiking cycles, producing an average 12-month return of 14.2% and an 8.2% average two-year annualized total. Preferred securities have also outperformed other fixed income classes, on average, coming out of rate-hiking cycles since 1990.

EXHIBIT 1

Preferreds typically have strong performance following rate-hiking cycles

At December 31, 2022. Source: ICE BofA, Cohen & Steers analysis.
Data quoted represents past performance, which is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any market forecast set forth in this presentation will be realized. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin. Preferred securities represented by the investment-grade-only ICE BofA Fixed Rate Preferred Securities Index (credit quality: BBB), investment- grade bonds represented by ICE BofA Corporate Master Index (credit quality: A-), high-yield bonds represent by ICE BofA High Yield Master Index (credit quality: B+). See end notes for index associations, definitions and additional disclosures.

CRN: 2023-0405-10770 R

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

Index definitions / important disclosures

An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes.

Preferred securities: ICE BofA Fixed Rate Preferred Securities Index tracks the performance of fixed-rate U.S. dollar-denominated preferred securities issued in the U.S. domestic market. Investment-grade corporate bonds: ICE BofA Corporate Master Index tracks the performance of U.S. dollar-denominated investment-grade corporate debt publicly issued in the U.S. domestic market. High-yield corporate bonds: ICE BofA High Yield Master Index tracks the performance of U.S. dollar-denominated below-investment-grade corporate debt publicly issued in the U.S. domestic market.

Data quoted represents past performance, which is no guarantee of future results. This material is for informational purposes and reflects prevailing conditions and our judgment as of this date, which are subject to change. There is no guarantee that any market forecast set forth in this presentation will be realized. This material represents an assessment of the market environment at a specific point in time and 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 is not being provided in a fiduciary capacity and is not intended to recommend any investment policy or investment strategy or take into account the specific objectives or circumstances of any investor. We consider the information in this presentation to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of appropriateness for investment. Please consult with your investment, tax or legal professional regarding your individual circumstances prior to investing.

Risks of investing in preferred securities. An investment in a preferred strategy is subject to investment risk, including the possible loss of the entire principal amount that you invest. The value of these securities, like other investments, may move up or down, sometimes rapidly and unpredictably. Preferred strategies may invest in below-investment-grade securities and unrated securities judged to be below investment grade by the Advisor. 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 and competitive industry conditions than higher-grade securities. The strategies' benchmarks do not contain below-investment-grade securities.

Duration risk. Duration is a mathematical calculation of the average life of a fixed income or preferred security that serves as a measure of the security's price risk to changes in interest rates (or yields). Securities with longer durations tend to be more sensitive to interest rate (or yield) changes than securities with shorter durations. Duration differs from maturity in that it considers potential changes to interest rates, and a security's coupon payments, yield, price and par value and call features, in addition to the amount of time until the security matures. Various techniques may be used to shorten or lengthen the Fund's duration. The duration of a security will be expected to change over time with changes in market factors and time to maturity.

Cohen & Steers Capital Management, Inc. (Cohen & Steers) is a U.S. registered investment advisory firm that provides investment management services to corporate retirement, public and union retirement plans, endowments, foundations and mutual funds.