Preferreds: Opportunity for quality income

The first quarter of 2022 is behind us, and the Federal Reserve has clearly made its mark across the fixed income landscape. The post-Covid upsurge in headline inflation has been exacerbated by Russian sanctions and the subsequent spike in commodity prices. With rising expectations for higher US policy rates, alongside the eventual commencement of quantitative tightening, US Treasury yields have soared and credit spreads have widened.

Though not an outlier, the preferred security asset class has now endured one of the worst starts to a New Year on record. That said, while the future still contains some uncertainty, we believe the bulk of negative price performance is behind us. In our view, preferreds currently look cheap, both on an absolute basis and compared to other segments of the bond market. Here are a few high-level observations:

• Depending on the issuer and structure, yields on preferreds now range between 4.5% and 6.5%. This is roughly 100–200bp higher over the last six months. For US taxpayers, qualified dividend income may lift the taxable-equivalent yield of certain preferreds between 5.8% and 8.3%.
• Negative sentiment about rising rates and retail ETF outflows has caused meaningful underperformance of low priced exchange-trade preferreds, relative to higher priced institutional preferreds
• The war between Russia and Ukraine and the subsequent sanctions on Russia has negatively impacted many European preferred issuers. Some high-quality issuers – even without significant Russia exposure – have preferreds which have become dislocated from fundamentals.
• Flat to inverted yield curves have weighed on financial common equity. However, higher short-term interest rates have increased the optionality of shorter-duration fixed-to-floating rate financial preferred equity. Certain LIBOR-based “currently callable” preferreds have seen their coupons recently reset higher by as much as 75bp.

An ugly quarter

With a volatile Q1 in the rear-view mirror, high-quality bond investors have now endured one of the worst starts to a New Year on record. While the preferred securities market held in relatively better than other fixed income assets, rising interest rates and declining risk appetites still fueled steep declines in price.

The ICE BofA Institutional Investment Grade (IG) Preferreds Index was down 5.15% for the first quarter, while institutional high yield (HY) preferreds were down 5.5%. The European contingent convertibles market fell by 5.95%, as these issuers were more heavily impacted by the crisis in Ukraine and sanctions imposed on Russia.

Low priced exchange-traded preferreds, by contrast, were sharply down 8.2%. Considered the retail portion of the market, low priced preferreds were hit by a combo of two elements: longer duration (as most securities are fixed-for-life) and selling pressure within the preferred ETF (exchange-traded funds) market, which mainly hold the low priced structures.

A more attractive future

As we head into Q2, we see the potential benefit of adding to preferreds with their combination of attractive yields, and now the potential for price appreciation. Though spreads (to US Treasury) have tightened from their weakest point in March, valuations remain cheap compared with earlier in the year. Moreover, yields have risen by nearly 200 basis points, to levels last seen during the peak of the Covid outbreak in Q1 2020. Today, when adjusted for credit quality, preferred yields are among the highest across most global fixed income markets (Fig. 1).