Preferred securities: Attractive entry point ahead of a Fed pivot

Inflation has been a major issue in the United States, owing to high oil and natural gas prices, partially a result of the conflict in Ukraine, which has hampered Russian exports of both commodities. In addition, pent-up demand after the COVID-19 lockdowns, coupled with supply chain issues, have elevated the prices of many goods and services. In fact, U.S. inflation had, at one point, risen above 9%.¹ Unsurprisingly, this only served to reinforce the U.S. Federal Reserve’s (Fed’s) aggressive monetary policy stance.

Preferred securities have historically outperformed fixed-income peers, including 2022

Understandably, this made 2022 a very difficult year for fixed-income investors, with investment-grade corporate bonds down some 15%—falling by almost the same degree as stocks on the S&P 500 Index. That said, data from the past year tells us that preferred securities have outperformed global corporate bonds by a significant margin in the first 11 months of 2022. This can be attributed to the high-quality nature of preferreds which, on average, is investment-grade credit quality (BBB) in addition to having a relatively low duration with less interest-rate sensitivity. It’s also worth noting that 2022 wasn’t the only year in which the relative performance of preferreds hasn’t outshone global corporate bonds.

During the periods of elevated inflation over the past 20 years, preferred securities have outperformed other fixed-income asset classes, with the exception of U.S. high-yield bonds, which have an average credit rating of B- (i.e., high-yield bond holders are exposed to a lot more credit risk than holders of preferred securities).

Broad range of preferreds could suit the changing environment

While investors can take some comfort from the past performance of preferreds (relative to their peers in the broader investment universe), there are many tools that investors can rely on in their toolbox, which, when combined with active management, can help investors generate potential excess returns while responding to the unfolding macroeconomic conditions.

For instance, under a hawkish Fed, amid rising rates and an inflationary environment (such as the one we’re in), we think active managers could—first—increase their position in floating-rate securities. These are older preferreds that were issued as fixed-to-floating rate securities and weren’t called on their initial call date and, therefore, have a floating-rate coupon. Also, these are mostly institutional preferreds in contrast to the many retail preferreds whose rates are fixed for life. As the federal funds rate has risen aggressively in 2022, these coupons, which reset quarterly, have also increased significantly. This has resulted in a lot of price stability amid a very volatile and downward-trending environment.

In addition, active managers could also increase their positions in junior subordinated notes because many of them are fixed-to-floating-rate securities. Again, these could help protect investors against a rapid rise in rates.

In a period of slowing U.S. growth or even a recession, it would typically make sense to increase exposure to baby bonds (senior debt). These are higher up in the capital structure relative to preferreds, which should provide some protection against spread widening amid an economic slowdown.

Three themes underpin preferreds in 2023: Higher quality, utility, and duration management

Aside from the tools that investors can lean on amid adverse market conditions, we’ve identified three themes that should underpin preferreds should the United States head into an economic slowdown or experiences a mild recession in 2023.

The most important among these themes is what we describe as quality play. We know that the Fed’s goal is to bring down inflation and that the U.S. central bank can only do this by slowing the economy. As such, investors should be careful and avoid securities that are susceptible to spread widening. While most preferreds are issued by high-quality companies, there are some low-quality preferreds that investors should stay away from. Also, because of the market conditions, we’d expect defaults to rise in the high-yield market. This is why we believe it makes sense to focus on overall credit quality. By focusing on quality companies, default risk will not be a big worry.

Our second theme is to continue with an overweight stance in the utility sector. We believe that many sectors within the S&P 500 Index will struggle in 2023, with earnings likely to face downward pressure. In contrast, utilities will likely show their resilience once again by maintaining earnings growth of between 5% to 7%, which we believe will outpace many other sectors.

Finally, our third theme: increasing duration. Many investors would have steadily decreased duration since two years ago on expectations that interest rates will rise. If the Fed slows down and eventually pauses rate hikes in 2023 as is widely expected, this would be positive for preferreds. This is because preferreds tend to perform well when rates are stable or declining. Given that we believe we’re nearing a peak in rates, it makes sense to start thinking about increasing duration again, partially by buying more fixed-for-life securities (retail preferreds). At the same time, it could be worth considering reducing exposure to fixed-to-floating-rate securities (institutional preferreds).

Preferreds should stay resilient, even in a recession

Having considered the opportunities available, let us turn to the track record of preferreds during challenging periods in the past. It’s worth noting that preferreds have typically performed fairly well during U.S. recessionary periods, especially in 2001. We expect them to perform much better relative to the 2008/2009 period given that:

• We're expecting an economic slowdown or a mild recession in 2023, but not a global financial crisis.
• Banks are in significantly better shape than in the past; their balance sheets are at their most robust in over 20 years.
• Banks are now heavily regulated and are well capitalized, meaning they’re much better able to withstand credit issues.

An attractive opportunity: positioned for a Fed pause or pivot

In our view, recent volatility has provided investors with more fixed-income opportunities. Compared with other alternatives in the fixed-income space, preferreds—as an asset class—represent a higher-yielding, lower-risk option. Data shows that preferred securities have the highest risk-adjusted return profile, with the highest annualized return (4.27%) over the past 10 years, and lower volatility/standard deviation (6.87%). U.S. Treasuries may have the lowest volatility (2.74%), but annualized return for the asset class was also low (0.69%). Crucially, we believe rising rates have created an opportunity to buy preferreds at attractive prices—many are trading at substantial discounts to par, levels not seen since the global financial crisis in 2009. Furthermore, yields for preferreds have risen above their 10-year highs.³ We believe this is appealing to investors who are searching for yield.

When the Fed pivots, preferred securities are expected to see a robust rebound, potentially delivering double-digit total returns for investors. In view of the attractive yields preferreds offers, a focus on high-quality names, an overweight stance in the utility sector, and greater investment flexibility, the asset class should be able to help fixed-income investors navigate the volatile and changing market while generating potential excess returns as U.S. interest rates stabilize.

1 The Bureau of Labor Statistics, November 2022. The U.S. Consumer Price Index (CPI) recorded a 9.1% year-on-year increase in June 2022, the fastest pace in four decades. The latest CPI was 7.7% in October 2022. 2 Preferred securities are represented by the Intercontinental Exchange (ICE) Bank of America (BofA) U.S. All Cap Securities Index. Retail preferreds are represented by the ICE BofA Core Plus Fixed Rate Preferred Securities Index. Institutional preferreds are represented by the ICE BofA U.S. Capital Securities Index. Global corporate bonds are represented by the ICE BofA Global Corporate Bond Index. Emerging-market bonds are represented by J.P. Morgan Emerging Markets Bond Index (EMBI) Global Diversified Index. U.S. corporate bonds are represented by the ICE BofA U.S. Corporate Index. U.S. Treasuries are represented by the ICE BofA U.S. Treasury and Agency Index. U.S. high-yield bonds are represented by the ICE BofA U.S. High Yield Index. It is not possible to invest directly in an index. Past performance is not indicative of future performance. 3 Bloomberg, as of November 30, 2022. The yield to maturity for preferred securities (using the ICE BofA U.S. All Capital Securities Index as proxy) reached a 10-year high of 8.05% between November 4, 2022, and November 7, 2022, above the 10-year average of 5.40%. As of November 30, 2022, the yield to maturity was 7.59%. 4 Morningstar and Manulife Investment Management, data as of November 30, 2022. Preferred securities are presented by the ICE BofA U.S. All Capital Securities Index. U.S. investment-grade bonds are represented by the Bloomberg U.S. Aggregate Bond Index. U.S. Treasuries are represented by the Bloomberg U.S. Treasuries Index. Global investment-grade bonds are represented by the Bloomberg Global Aggregate Bond Index. U.S. high-yield bonds are represented by the ICE BofA U.S. High Yield Index. Emerging-market bonds are represented by the J.P. Morgan EMBI Global Diversified Index. It is not possible to invest directly in an index. The above information is for illustrative purposes only and does not constitute any investment recommendation or advice. Past performance is not indicative of future returns.