The case for subordinated securities

A quartet of portfolio managers share their views on subordinated securities, their risks and their attractive yields.

For Bill Scapell, the Cohen & Steers SICAV Global Preferred Securities fund’s portfolio manager, preferred securities offer yield, diversification and rate risk mitigation.

“Investment-grade preferred securities typically offer some of the highest income rates in high-grade fixed income markets, with yields that have recently been competitive with high-yield bonds. As of 31 March 2017, preferreds had higher yields than all the main “core” categories and all the selected non-core groups except high-yield bonds. This above-average income component has contributed to attractive total returns over time while often providing a cushion in down markets.

“Preferred securities have also had diversifying correlation with equities and other non-traditional asset classes. This is partly because banks and insurance companies, the largest issuers of preferred securities, are typically not well represented in other fixed income strategies, such as high-yield bonds. Low correlations with other asset classes provide strong evidence for preferred securities as a portfolio diversifier.

“In addition to offering traditional pure fixed-rate securities, the preferreds universe contains other structures, including fixed-to-float securities that dominate the OTC market (and are available on a more limited basis in the exchange-traded market).

“As their name implies, these instruments pay a fixed coupon rate for a specified period, after which the coupon may reset based on movements in an interest-rate benchmark. Such lower-duration securities have proven to help cushion the impact of a rising-interest-rate environment (as coupons adjust upward), and active investors can choose from a wide variety of liquid structures to help manage rate risk.”

Hybrids provide quality, sustainable yields, says Julian Marks, portfolio manager of the Neuberger Berman Corporate Hybrid Bond fund.
“First, consider the quality of the issuers. More than 90% of those in the Bank of America Merrill Lynch Global Euro Investment Grade Hybrid Non-Financial Corporates Index are public companies rated by one—if not all—of the three leading agencies.

“Nearly all the issuers (and more than 70% of their securities) are investment-grade, which should come as no surprise given the preponderance of stable utilities and telecoms among their number.

“How much spread are investors paid for this? The difference in yield between hybrids and the average investment-grade bond is 200 basis points. To get the same spread in senior debt today, investors would have to go to high-yield issuers rated BA2/BA3 or BB/BB. We believe that spreads more than compensate for the subordination: even after factoring in a premium for that risk, we estimate that there are more than another 100 basis points of spread available from hybrids relative to senior, on average.

“Hybrids slip through a gap in traditional fixed income coverage. While investment-grade portfolio managers will know the issuers, they may be uncomfortable with subordinated capital. High-yield managers, on the other hand, are unlikely to have carried out credit research on these issuers. In addition, this may be a case of value being in the eye of the beholder.

“To investors, hybrids look like great value relative to investment-grade senior and adjusted for subordination risk, whereas, to finance directors, hybrids look like great value relative to issuing equity—partly due to the tax advantages of debt over equity.”

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