CIO thinks investors should look to gain diversified exposure to the sector by taking advantage of a variety of structures and coupon types. (UBS)

Year-to-date, both USD 25 par and USD 1,000 par preferreds are outperforming investment grade and high yield bonds. Despite the impressive gains already accrued, we continue to believe that preferreds look well positioned to benefit from a more benign rate backdrop in 2023. The sector’s outsize losses last year were attributable to an epic surge in interest rates, driven by the Federal Reserve’s most aggressive monetary policy tightening in decades. But a more favorable inflation outlook and less hawkish Fed should provide a more supportive backdrop for the preferred sector, especially given current valuations.

The sector’s rally over the past few weeks has occurred despite the headwinds of preferred ETF outflows. In fact, preferred ETF flows were predominantly negative throughout 2022. These outflows exacerbated losses, especially for the USD 25 par sector, since preferred ETFs generally focus on exchange-listed USD 25 par securities. Last year, preferred ETFs experienced 39 weeks of outflow, and except for six consecutive weeks of inflow during the summer months, flows were fairly consistently negative throughout 2022. Weekly outflows averaged USD 150mn. Outflows have continued thus far in 2023 for two of the year's first three weeks. However, as interest rates stabilize, this may support the sense that market yields have peaked. Coupled with yields that are still around 6%, this could encourage more consistently positive inflows this year, which might provide an additional tailwind to the sector—adding to the more stable rate environment.

Sector yields have declined in recent weeks as preferred prices have rebounded. However, in our view, yields remain attractive relative to historical trends and to other yield sectors, especially when considering that a majority of preferreds are associated with high-quality issuers in the bank and finance sector, including the US globally systemically important banks (G-SIBs).

In our view, investors should look to gain diversified exposure to the sector by taking advantage of a variety of structures and coupon types. For more details, see “A promising proposition in preferreds,” 31 October 2022 and “There’s a pref for that,” 22 November 2022. For specific preferred recommendations, check out the latest monthly update to the Preferred Securities: Top Picks Portfolios, "Positive outlook," 12 January 2023.

Main contributor: Frank Sileo, Fixed Income Strategist

Content is a product of the Chief Investment Office (CIO).

Original report - Impressive rally for preferreds – now what?, 24 January, 2023.