After holding a neutral position in preferred securities since August 2022, we now recommend moving to a most preferred as we view both carry and capital (price) appreciation as performance drivers during 2H23. While most of the negative impact on price due to rising interest rates occurred in 2022, this year the performance driver has shifted to rising credit spreads. The charts below show the risk-free rate and credit spreads for the sector. Spread widening, in conjunction with price depreciation in 2023, had proven a strong enough headwind to ignore the positive returns from declining US Treasury yields. The correlation of preferred performance to the regional banking index increased in March and April, even though most of the financial sector is composed of larger banking institutions. This instability of regional banks in March and April created an unanticipated market headwind that resulted in a the largest divergence in years in price and yield between financial and nonfinancial preferreds.
While we remain selective on the sector as tightening lending standards and higher borrowing costs may result in pockets of vulnerability over the next six months—particularly given our “higher for longer” Fed view—we do not see a banking crisis on the horizon. With the Federal Reserve likely near the end of its rate hiking cycle this summer, alongside the recently more hawkish view of the Fed’s path—only one rate cut is priced in starting December 2023—we prefer to be opportunistic and lean toward a longer stance within our interest rate exposure. We have guided our investors not to chase rate moves lower despite our year-end bullish stance. We have disagreed with the dovish outlook the market priced in over the past two months and recommended waiting until 2023 easing was priced out given the strength of the labor market and continued elevated inflation.
Preferreds have the benefit of being of higher quality. The index is rated BBB, representing higher embedded interest rate risk at a time when the Fed is near a pause, likely leading to a pivot in 2024, alongside the enhanced income earned. Despite their higher quality, preferreds are now cheap relative to investment grade (IG) corporates, and preferred spreads have been behaving closer to BB rated high yield (HY), as tighter lending standards continue to impact smaller regional banks. CIO’s recommendation has remained in higher-quality segments, including those financials within the preferred universe.
Given the rise in interest rates, we have recommended fixed-rate over floating-rate preferreds, particularly as the second half of the year progresses. The bulk of the floating-rate hedge to rising interest rates is now behind us, and although a hard landing may not be in the cards, the economy will continue to slow in the second half especially given the high probability that the Fed is near, but not at, the terminal rate, and one or two more rate hikes cannot be ruled out.
Currently, preferreds’ higher-quality embedded interest rate risk and yield are providing a lot of cushion for investors should the economy deteriorate beyond our expectations in 4Q23. While the global financial crisis remains an anomaly, in previous recessions spreads did widen, producing negative excess returns. In today’s market, however, the carry component should outperform the spread-widening impact as the interest rate component will be a positive contributor to declining Treasury yields, considering our view that a banking crisis will likely not be an event over the next several months, particularly within the larger G-SIB institutions.
Main contributor - Leslie Falconio
Content is a product of the Chief Investment Office (CIO).
Original report - Value in preferreds, 30 May 2023.