Preferred securities lie between common stock and bonds in a company’s capital structure. If the issuer goes bankrupt, the preferred shareholders stand ahead of the common stockholders but behind senior debt holders in the payback line—presenting subordination risk that partly explains preferred securities’ higher income. Preferred payments are also subject to deferral or outright omission, although such actions are extremely rare in practice, typically occurring only in cases of significant corporate stress.
Given the technical possibility of an omitted payment, investors demand high-quality, tested and stable business models to provide an adequate comfort level around expected income. It’s no coincidence, therefore, that preferreds are issued mainly by large, highly regulated institutions and/or companies with steady and transparent cash flows such as banks, insurance companies, utilities, telecommunication companies and real estate investment trusts. In fact, investors will find little in the way of cyclical or smaller companies in the preferred universe in general.
Preferreds Active Managers Have A Decided Edge Over ETFs
To our continued bewilderment, investors seeking access to preferred securities have heavily favored ETFs over actively managed funds. Flows into preferred ETFs dominated those of open-end mutual funds by 3 to 1 in 2015. The shift toward passive vehicles is understandable for some investments. But preferred securities are one asset class where this approach makes no sense, in our view—for very clear reasons.
Preferred ETFs invest only in $25-par exchange-listed securities, which represent less than one quarter of the nearly $1 trillion global preferred securities universe. By contrast, certain actively managed funds may also invest in the much larger institutional OTC market, which offers a far wider array of issuers and security structures, including numerous overseas opportunities. ETFs’ narrower focus not only limits their holdings, but precludes them from many new investment opportunities, since the vast majority of new preferred securities being brought to market today are being issued into the OTC market.
Importantly, active managers also have the ability to dynamically position a portfolio based on their outlook for the economy and interest rates. Active managers conduct fundamental credit analysis to identify securities that offer attractive yields and/or company-specific catalysts that could result in tightening credit spreads and ratings upgrades. Managers also have a variety of tools to manage a portfolio’s interest-rate risk—for example, by concentrating assets in lower-duration securities.
While different investors have different needs, we believe there are material reasons to consider the advantages of working with an active manager who specializes in preferred securities, particularly at a time of heightened economic uncertainty.
Mitigating Interest-Rate Risk With Low-Duration Preferreds
Investors whose primary experience with preferreds is through ETFs may perceive that preferreds are highly sensitive to longer-term interest rates. This is because the exchange-traded market is dominated by securities with fixed-rate structures, generally giving them a high duration. (Duration is a measure of an asset’s sensitivity to changes in interest rates, or yields. The higher the duration, the greater the price will change in response to a given rise or fall in interest rates.)
By contrast, the institutional OTC market is composed primarily of lower-duration fixed-to-floating rate preferred structures. These securities typically pay a fixed coupon for a certain period—often five or ten years—and then convert to a floating-rate structure, drastically reducing their interest-rate sensitivity compared with fixed-for-life structures.