Weekly Review: Fixed-Rate Preferreds Finally Get Some Love

This article was first released to Systematic Income subscribers and free trials on Jan. 15.

Welcome to another installment of our Preferreds Market Weekly Review, where we discuss preferred stock and baby bond market activity from both the bottom-up, highlighting individual news and events, as well as top-down, providing an overview of the broader market. We also try to add some historical context as well as relevant themes that look to be driving markets or that investors ought to be mindful of. This update covers the period through the second week of January.

Be sure to check out our other weekly updates covering the business development company (“BDC”) as well as the closed-end fund (“CEF”) markets for perspectives across the broader income space.

Market Action

Preferreds continued to rally this week, led by the Telecom, BDC (i.e. PSEC.PA) and mREIT sectors. Bringing up the rear are CEFs and Energy stocks. The CEF preferreds sector is largely a higher-quality sector and has a relatively low beta.

Preferreds yields have fallen along with other fixed-income sectors towards a still respectable 6.5% level.

Market Themes

January brought some relief to longer-duration assets. As many preferreds investors know full well, 2022 was hard on longer-duration assets. In the preferreds sector this means Fixed-rate preferreds and Fix/Float preferreds with longer call dates underperformed.

The chart below shows performance between Bank Fixed-rate and Fix/Float preferreds. Most months last year saw an underperformance by Fixed-rate preferreds, in response to rising Treasury yields.

January brought some relief to Fixed-rate preferreds as they outperformed Fix/Float preferreds by around 6%.

Last year we highlighted the value of slowly adding to some high-quality Bank preferreds in response to rising Treasury yields in the scenario that Treasury yields reverse their rise in response to subdued inflation or in the scenario a recession is followed by the typical pattern of rising credit spreads and falling Treasury yields.

The proximate cause of the drop in Treasury yields over the last few months is the disinflation, particularly in energy and goods prices and the Fed guiding towards a slower pace of hike and an eventual pause. This development has driven many low-coupon Fixed-rate Bank preferreds up by double-digit levels.

Stance And Takeaways

Given the current environment of tightening credit spreads and high short-term rates, a barbell allocation for new capital of higher-quality fixed-rate alongside floating-rate preferreds makes a lot of sense.

On the former, stocks like (COF.PJ), (KEY.PJ) and (WFC.PL) which trade around 6-6.2% yields can fit the bill.

On the latter, we particularly like low spread preferreds i.e. those preferreds which pay a coupon of Libor + 1% or even lower. These preferreds have a low spread over Libor which means that the further rise in Libor (although Libor has slowed its rise recently, there is a lag with which Libor is passed through to preferreds coupons) will disproportionately increase the coupons of these preferreds relative to more typical Libor floating-rate preferreds which have spreads set at 3-5%.

This disproportionate increase should also translate into a larger price pop for these stocks in order for their yields to remain similar to their sister preferreds, which otherwise would be left behind in yield terms.

These stocks include (USB.PA), (USB.PH) and (GS.PA) which should boast yields north of 7% despite their investment-grade or near investment-grade quality. One thing to watch out for is that these stocks can also underpeform disproportionately to the downside. Once the Fed signals their readiness to take rates down it would make sense to rotate to fixed-rate counterparts of the same issuer.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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