The opportunity set of low-duration preferreds is quite large, with more than $500 billion worth of preferred securities featuring durations of five years or less. We believe that access to both the exchange-traded and OTC markets is essential over the course of an interest-rate cycle, as some securities will fare better than others depending on market conditions.
The Tailwind Of Global Financial Reform
In the aftermath of the financial crisis, stricter banking and insurance regulations enacted in the United States and elsewhere have forced many institutions to shore up their balance sheets and reduce business risks. These financial reforms are not only driving stronger credit fundamentals for preferreds, but have also spurred a global wave of refinancing opportunities as companies redeem old-style preferreds that no longer qualify as Tier-1 equity capital and issue new preferreds that count toward their regulatory capital requirements.
One new structure inspired by stricter regulation is the contingent capital, or CoCo, security, which has become the new standard for many foreign banks. Unheard of just a few years ago, the CoCo market has grown exponentially and now represents over 15 percent of the global preferred security universe, with large European banks being the most prevalent issuers. CoCos differ from other preferreds in that they have explicit loss-absorbing mechanisms triggered by large changes in regulatory capital. Compensating investors for their unusual features and abundant new supply, CoCos offer investors comparatively high yields and can represent an appealing opportunity for investors who can assess and manage their risks.
Attractive Qualities For Today’s Challenges
As investors search for answers on how to generate high and stable income while navigating higher interest rates and turmoil in high yield, we believe preferred securities are well positioned for the current environment. With further rate hikes on the horizon, the high income levels and low duration structures offered by many preferred securities may help protect investors from a total-return perspective. Yield premiums relative to Treasuries are also well above what they were before the financial crisis, which can provide a cushion against the effect of rising rates.
What is more, unlike the deteriorating fundamentals in the high-yield sector, balance sheets for many preferred securities issuers are as strong as they’ve ever been—and getting stronger with high regulatory hurdles set for the years ahead. As companies continue to bolster their capital in line with rising regulatory requirements, this could lead to tighter spreads and credit ratings upgrades, ultimately buoying the price of preferred securities.
As always, investors should consider the risks of any investment. If interest rates rise significantly, preferred securities may lose value. Preferreds are also sensitive to forces that affect credit markets broadly. But when viewed in the context of a diversified portfolio, we believe preferred securities offer a compelling combination of high income and diversification potential, backed by a strong track record of positive returns in a variety of market environments.
William Scapell, CFA, is executive vice president at Cohen & Steers and the firm’s director of fixed income.