The steepest rise in short-term interest rates since the Volker era and recent bank failures connected to the rate cycle have put heavy pressure on preferred securities prices. Rising rates and uncertainty about the banking sector’s health have led investors to paint these securities with a broad brush of fear. As a result, preferreds are trading at deep discounts to par value—around 86 cents on the dollar, on average, for one segment of the market—discounts that have not been seen since the global financial crisis (GFC).
We believe these concerns are mostly unwarranted, considering the healthy fundamentals of preferreds issuers, and that a substantial capital appreciation opportunity exists for investors. Furthermore, preferreds currently offer yields around 6-9%, superior to other fixed income categories and higher than their historical averages, with the potential to produce equity-like long-term returns.
Not All Banks Are Alike
Despite overly negative headlines, we do not believe we are witnessing another GFC—far from it. Recent bank failures resulted from poor management of quantitative easing excesses and subsequent quantitative tightening as central banks grappled with inflation. In contrast to the GFC, broad credit excesses are not an issue today; nor is bank capital, which is far above historical averages and in keeping with the much higher regulatory requirements implemented following the GFC.
We believe the failed banks shared certain characteristics that are not widely shared by other U.S. banks. Notably, the failed banks experienced extreme deposit growth during the Fed’s quantitative easing phase—over 75% since 2020—and had highly concentrated depositor bases. Most other banks experienced far smaller deposit growth in recent years, generally in the single- to low double-digits.
In addition, the failed banks invested their substantial deposit flows into longer-term securities when rates were low. As a result, although the securities purchased were high quality, the holdings fell in value when the rate cycle ferociously turned, creating an asset/ liability mismatch and unrealized capital weakness. Most other banks did not invest heavily in longer-dated securities when overnight rates were low and are therefore well capitalized even net of securities marks.
Outside of the U.S., we believe that Credit Suisse was also an outlier, as it struggled in recent years with very weak profitability following large credit losses and litigation issues in 2021. We do not view other large European banks as having anywhere near Credit Suisse’s level of vulnerability.
While most banks are in good shape, some are clearly stronger than others. We believe very attractive entry points exist in depressed securities from many stronger banks. Other issuers such as insurance companies, utilities and other non-financials have also seen their preferreds under pricing pressure along with the broader market. In our view, this presents an attractive investment opportunity across most issuers within the asset class.
Tailwinds For Preferred Holders
Weakened bank supervision notably contributed to recent bank failures, as GFC-era enhanced supervisory procedures were relaxed by Congress in 2018 for all but the largest banks. As such, we expect the imposition of new measures that will strengthen bank regulation and bolster the resiliency of the financial system.
The new rules will likely include higher capital and liquidity requirements. Although bank stocks have come under pressure on the prospect (as reforms may weigh on profitability), we believe the remedies will be supportive of credit over the long term. Recall that coming out of the GFC, tighter regulations benefited creditors for many years, particularly preferred holders.
Additionally, history shows that preferred market corrections are typically followed by strong returns. For perspective, in the six market corrections going back to the global financial crisis, preferred securities meaningfully outperformed U.S. bonds in subsequent months, typically generating equity-like returns in the process.
Preferreds also tend to outperform in the 12 months following the last rate hike, which we believe is approaching. On average, preferreds have historically returned 14.2% in the 12 months after the last hike, compared to corporate bonds returning 12.6% and high-yield bonds producing 11.8% returns.
Leveraging The Opportunity
Preferred securities’ high income, coupled with discounts to par value not seen since the global financial crisis, presents what we believe is an attractive total return opportunity for investors. We believe the end of the Fed’s rate increases and more robust bank regulation will be powerful catalysts for the new cycle. But diversification and active management remain key in volatile markets. Active managers can potentially maximize returns by investing across sectors; looking deeper into fundamentals, valuation metrics and risks; and taking action as valuation opportunities present themselves.
Bill Scapell is head of fixed income and preferred securities at Cohen & Steers. Elaine Zaharis-Nikas is senior portfolio manager of fixed income and preferred securities at Cohen & Steers.