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By Andrew C. Arbesman, CFA, CPA
U.S. bank preferreds offer investors attractive risk-adjusted returns relative to similarly rated credit.
We remain confident in the soundness of the financial system and maintain a constructive credit view of the banking sector. Banks learned painful lessons during the financial crisis and have been de-risking their balance sheets for a decade.
Today, they have higher capital requirements, robust liquidity, stable funding and lower leverage. In our view, banks are likely to remain committed to these standards, protecting both creditors and shareholders during the current period of heightened volatility and uncertainty.
Given our confidence in the U.S. banking system, we feel comfortable moving down the capital stack of banks to pick up additional yield. In particular, bank preferreds offer compelling risk-adjusted returns relative to similarly rated credit.
The preferred market has not been immune to the difficult market conditions in 2022. The rapid move in rates coupled with increased market volatility contributed to underperformance.
Yet, despite negative returns so far this year, the preferred market has performed in line with, to slightly better than, other markets such as BBB corporates, BB corporates and high yield. Additionally, preferred yields appear attractive, offering significant yield pick-up versus BBB corporates, as an example.
In our opinion, the yield pick-up bank preferreds offer is more a function of a complexity premium than credit risk. Very rarely are preferreds similar in structure, ranging in differences such as duration/extension risk, reference rate and reset spread.
Therefore, unlike other fixed income securities, preferreds from the same issuer can demonstrate remarkably different total returns over a given period of time.
Another reason bank preferreds offer attractive yield pick-up is the lack of a dedicated investor base. The dedicated preferred investor base relative to the overall size of the preferred market is one of the most mismatched asset classes out there. This can lead to more severe swings in valuations during periods of heightened volatility.
This volatility, however, can create investment opportunities and offers investors exposure to strong credits in a sector benefiting from positive credit fundamentals.
For investors who can cut through the complexity of preferreds and thereby identify superior structures while performing robust credit analysis, U.S. bank preferreds offer an attractive investment option to potentially realize outsized gains over a longer time horizon.
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