Investors finding attractive income in preferred securities

As interest rates in the US continue to rise – and other central banks move tentatively towards tightening – investors are increasingly looking for ways to preserve capital and reduce interest-rate-driven volatility. The trend of rising rates has also underscored the importance of being diversified, especially with many investors turning to risky bonds for yield. We believe investors can meet these challenges with an allocation to preferred securities, helping to enhance current income while offering distinct characteristics that may complement traditional bond holdings.

Diversifying characteristics

Preferred securities are mostly issued by companies with high credit ratings, yet generally offer yields in the 5–7% range; a similar yield to bonds yet several notches lower in quality. With junk bonds, high income rates are typically a reflection of poor balance sheets, indicating a higher risk of default. With preferred securities, the extra income is mostly to compensate investors for subordination, as well as the general complexity of preferred security structures and the possibility that payments may be omitted or deferred – which is historically rare. Because the risks of preferred securities are typically different than those of other high-income securities, investors may be less vulnerable to stress in any one area of the market.

Preferreds are typically offered by companies in highly regulated industries such as banks, insurance companies and utilities, as well as hard-asset, high-cash-flow companies such as real estate investment trusts. The relative stability of cash flows provides a level of confidence that coupons will be paid. By contrast, the high-yield market is more concentrated in cyclical sectors such as energy and basic materials, historically leading to higher volatility.

Security structure is key

Because preferreds are typically issued without a maturity date, they are often perceived as being highly interest-rate sensitive. However, the preferred market is composed of securities with a variety of structures—including many with relatively low durations—that can help buffer a portfolio’s interest-rate risk.

The preferred securities typically found in the exchange-traded market pay a fixed coupon in perpetuity, often resulting in relatively long durations. By contrast, fixed-to-float securities—which dominate the institutional over-the-counter (OTC) market—pay a fixed rate over an initial period, after which they reset to either a floating rate or a new fixed rate. This feature may reduce price sensitivity to changes in interest rates. Other structures include pure floating-rate securities that have a near-zero duration, since they reset frequently based on movements of a benchmark interest rate.

Due to the variety of security structures, roughly two-thirds of the preferred market has a duration of five years or less.

Fundamental tailwinds

We believe banks and insurance companies, which are the primary issuers of preferred securities, should continue to benefit from a rising-rate environment, as higher rates continue to drive improvement in net-interest margins. In the US, somewhat reduced regulatory burdens and lower tax rates are proving beneficial for financial companies, reducing regulatory costs and increasing earnings, which should lead to stronger balance sheets. Meanwhile, financial institutions in Europe and Asia Pacific continue to adapt to new regulatory capital requirements, issuing new types of preferreds that often include attractive features and high-income rates to entice investors.

For investors looking to diversify fixed income holdings and enhance potential returns, we believe preferred securities are an attractive solution. Preferreds offer a variety of structures for managing interest-rate sensitivity, along with high yields that may help to cushion any potential price decline resulting from rising rates.

 

William Scapell is head of Fixed Income and portfolio manager of the Cohen & Steers Global Preferred Securities Strategy

preloader
Close Window
View the Magazine



I also agree to receive editorial emails from InvestmentEurope
I also agree to receive event communications for InvestmentEurope
I also agree to receive other communications emails from InvestmentEurope
I agree to the terms of service *


You need to fill all required fields!