Top themes spotlight: Floating on with preferred securities

Rising rates creating opportunities

Overall, US economic data and Fed commentary over the past several months have driven a shift in the outlook for inflation and monetary policy. This continues a broader market trend over the past year toward higher rate expectations. Over the past two years, financial credit spreads have tightened on the back of a more supportive business operating environment. Generally speaking, rising rate expectations and tighter financial credit spreads are supportive of fixed-to-floating rate coupon preferreds (F2Fs) with near-dated calls, given that trading levels in these securities benefit from tighter spreads in addition to the potential for higher income.

The potential for higher coupon income stems from increases in the Fed funds rate and rising yields on short-term Treasury bills, which have contributed to increasing LIBOR rates over the past year. F2Fs convert to a floating rate based on LIBOR, meaning that F2Fs with near-term call dates stand to benefit from a rising cash flow stream in the event the preferred is not redeemed at the earliest possible date. We believe investors should consider F2Fs as being akin to a traditional fixed-rate preferred with a "call option" on interest rates. When investors expect rates to rise, the option value (to the investor) increases, but when markets expect rates to fall, the option value declines.

In 2018, higher interest rates have created broad headwinds for fixed income in general, especially segments with longer durations. Among F2Fs, those with long-dated first call dates beyond 2021 have been pressured as well. Long-dated calls provide more call protection but leave investors more exposed to duration risk. In addition to having more duration, F2Fs with longer-dated calls are susceptible to the possibility of fading in the supportive trends that have bolstered the sector over the past 18 months (i.e., spread compression, rising rate expectations, etc.) between now and the first call dates. This makes the back-end reset spread more important for this group. Among F2Fs with call dates beyond 2021, we believe the back-end reset spread becomes more important and we favor those with high resets. As an alternative, investors may consider F2Fs with near-dated calls between 2019 and 2021. They offer attractive yields relative to their low duration and should benefit from the continued expectations for rising rates.

We believe investors should consider F2Fs as being akin to a traditional fixed-rate preferred with a "call option" on interest rates.


Investment recommendations

We continue to view US banks as an attractive sector for investors seeking to gain credit exposure. As the economic and credit market cycles continue to mature, we believe US banks remain an attractive option, characterized by defensive features stemming from the phase-in of the Dodd-Frank Act (DFA) in 2014. With the tailwind of regulation, banks have been forced to build robust equity capital positions, de-leverage balance sheets, and de-risk operations. We believe these actions have resulted in stronger operating profiles that may lead to bank fixed income largely sustaining credit quality during periods of potential economic weakness.

For investors looking to gain exposure to attractive yields with minimal duration risk and solid underlying credit fundamentals, our favored positioning is F2Fs with near-dated calls.  While not our base case, key risks to this positioning would include sudden economic deterioration that leads to lower rate expectations and a widening of bank credit spreads.

We continue to view US banks as an attractive sector for investors seeking to gain credit exposure.

Frank Sileo, CFA

Senior Fixed Income Strategist Americas
CIO Global Wealth Management

Dan Kelsh

Senior Fixed Income Strategist Americas
CIO Global Wealth Management

Barry McAlinden, CFA

Senior Fixed Income Strategist Americas
CIO Global Wealth Management

Laura Kane, CFA, CPA

Head of Investment Themes Americas
CIO Global Wealth Management


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