By Partner & Portfolio Manager, Kevin Kelly
The year-to-date return on the preferreds issued by Bank A range from +1% to -20%, while the year-to-date return on the preferreds issued by Bank B range from +2% to -20%. This variation in performance among preferreds issued by the same bank comes as a shock to most investors. However, knowledgeable preferred investors are not surprised and highlight the importance of security selection. 2022 has proven this true in a rising rate and widening credit spread environment. So how can two preferreds from the same bank perform so differently?
The main source of variation among preferreds is the coupon. Preferreds generally come in two very different coupon structures, a fixed rate or a variable/floating rate coupon. In a changing interest rate and credit spread environment, these perform very differently. A fixed rate coupon never changes, while a variable/floating security has a coupon that resets to the interest environment on a regular, periodic basis. The reset benchmark and how often the coupon resets will vary, but most importantly, this security has a substantially lower duration (interest rate risk) than a fixed coupon security. When interest rates rise, a variable preferred only has interest rate risk until the next coupon reset date (typically from 3 months to 10 years post issuance). For illustrative purposes, a preferred’s coupon may reset to the 5-year Treasury rate plus 4.00%. If this happened today, the coupon would become an approximately 7% coupon for the next 5 years. For a fixed coupon security, by contrast, a large interest rate increase could significantly impair the market value of such a security. For example, a 4% coupon security, in a market that suddenly demands a 5% yield on preferreds, will correspondingly trade down to a price of $80. This illustrates our concerns about the downside of owning low 4% fixed-for-life coupon preferreds, as we mentioned in a previous commentary.
Since yield equals interest rate plus a credit spread, the coupon on a preferred must also compensate investors for the credit risk assumed. A low-to-mid 4% fixed coupon preferred leaves little margin of error for interest rates to rise or credit spreads to widen. This explains why many of these low-to-mid 4% fixed coupon preferreds have returned negative 10-20% in 2022. While a variable/floating rate preferred has much less interest rate risk than a fixed rate, the variable preferreds must still provide an attractive credit spread. For example, a variable preferred with a coupon equal to the 5-year Treasury plus 2.75% may simply not provide adequate yield for the commensurate risk. Therefore, investors must be very careful to select fixed and variable rate preferreds that protect both interest rate and credit spread downside risk.
Buying the wrong preferred can be a very costly mistake. Preferred investors cannot simply wait until maturity (assuming no bankruptcy) to recover par because most preferreds have no maturity (or are extremely long-dated). So, while most fixed investors currently have paper losses on their bond portfolios, they can choose to simply hold these until maturity. Investors who buy the wrong preferreds may be stuck with securities that never trade back to par (depending upon the long-term fixed income environment). Many preferred investors simply do not realize how much principal loss risk they are taking by casually buying preferreds.
Another complication is that most preferreds are callable at the Company’s option. This means if a security’s coupon is substantially above market, an investor should realize this security likely will get redeemed/called at some point in the near future. Unfortunately, some investors do not realize this and they confuse the coupon and the “yield-to-worst.” For example, if a 6% coupon preferred trades at $26.50 and is callable/redeemable in two years, this security actually yields less than 3% if it is called in two years, as appears likely. Please see the illustrative example below. Additionally, investors need to compare the yields available on preferreds to other fixed income alternatives. While it does not usually make sense, some preferreds trade at a lower yield-to-worst than bonds with the same rating and expected redemption.
The reasons discussed highlight that indiscriminatingly buying preferreds is potentially hazardous to your long-term wealth. Security selection is everything in preferred investing. This becomes painfully obvious during challenging market conditions. The preferred market, especially for exchange-traded preferreds, is one of the most inefficient segments of fixed income because many investors fail to realize what they are buying. For knowledgeable investors, this inefficiency often creates great opportunities. This is why individuals buying preferreds should either hire an investment manager or ensure they are well versed in the nuances of preferreds.
Coupon versus yield preferred example
If an investor buys a 6% coupon preferred at $26.50 that is likely to be redeemed in two years at $25.00, what is the yield or return?
• The investor will receive $1.50 per year (6% * $25 = $1.50 dividend)
• Outflow: $26.50 purchase price
• Inflows: $1.50 per year * 2 years = $3.00 + $25.00 at redemption = $28.00
• Total return is $28.00 – $26.50 purchase price = $1.50 return, or $0.75 per year, which equals an annual return of approximately 3% (2.9% to be precise)
• Some Investors think they are paying $26.50 to receive 6% or $1.50 per year forever, but this is not the case if the preferred is redeemable at $25 in two years.
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.