Looking for diamonds in the rough? Consider a ‘preferred’ approach
Preferred equities have been pressured to the point where they now seem attractive. Here’s why.
Markets in a Minute: Inflation: still hot, still broad
The latest inflation data put a dent in the idea that price pressures could deteriorate faster than the labor market. The June CPI report showed that prices rose 9.1% relative to last year and 1.3% relative to last month. Both were well above Wall Street consensus estimates, and likely ensure that the Federal Reserve raises rates aggressively at their next meeting at the end of the month. The fact that the Fed (and other global central banks) could still accelerate the pace of rate hikes increases the chance that the labor market cracks under the pressure.
Sure, food and energy prices drove an outsized share of the print, but the breadth of price increases across categories does not offer evidence of relief elsewhere. Important categories such as rent and healthcare services accelerated between May and June, and durable goods categories like motor vehicles and furniture remained very elevated. We could do a nuanced breakdown of the individual drivers, but there isn’t much utility in that. The Fed is solely focused on bending inflation back to target and this showed that they are still far from that goal.
The bond market reaction fits with what you would probably expect. Fed Funds futures now imply that a 100 bps hike at the next meeting is on the table. Two-year yields rose while 10-year yields actually fell, and the 2s10s yield curve moved to its most inverted level since 2000. In fact, markets are now suggesting that short rates will decline by ~80 bps in 2023. The market thinks that this year’s aggressive tightening will abruptly become easing next year.
In all, this latest data point makes us incrementally more pessimistic on the near-term economic outlook. But we should also note that risk assets are already well on their way to pricing in this more negative news. Despite the objectively bad inflation data, the equities that have been most harmed by higher inflation and interest rates outperformed this week. While we are probably not at the bottom yet, pockets of opportunity are starting to emerge.
Spotlight: Finding value in preferred equities
The only good thing about bear markets is that they eventually provide attractive entry points for risk assets. Right now, we think there is an attractive entry point in preferred equities.
Preferred equities are securities that have some bond-like characteristics (they pay a consistent cash-flow stream to the holder), and some equity-like characteristics (subordination to other forms of debt but the potential for capital appreciation). The most common type of preferred equity is issued by banks, who use the capital to meet regulatory requirements, but companies in other industries can be issuers as well. Importantly, the income that preferred equities pay U.S. investors is typically taxed at qualified dividend rates, which are less onerous than ordinary income rates.
So far this year, preferred equities have been under pressure because of both higher interest rates (like bonds, they suffer when interest rates rise) and the growth slowdown that is underway (like equities, lower potential earnings puts the cash flows at risk). But now we think they have reached a level where it makes sense to consider adding to the asset class. There are three reasons why.
The first is valuation. Similar to other areas of fixed income, we value preferred equities by looking at the difference between their yield and the yield on risk-free rates. When the spread is wider, markets are more skeptical about actually receiving future cash flows. Right now, with all-in yields over 7% and spreads over 400 bps, we think investors are being compensated fairly for the risk that preferred dividends stop getting paid. In the other two periods over the last 10 years when spreads rose above 400bps, the median 12-month forward return was over 20%.
Next, the risk of default across the asset class is low. Preferred equity issuers are typically investment-grade companies with solid balance sheets. This differentiates preferred equities from high-yield bonds, where losses from defaults will likely eat into the headline yield that an investor could otherwise receive. This is true for the banking system in particular. Today, U.S. banks are highly regulated, systemically important entities with historically conservative balance sheets. The loan-to-deposit ratio for U.S. banks (one of the more basic measures of leverage) has dropped from almost 100% in October 2008 to near 60% today. Bank earnings may be lower as the economy slows, but we do not think that the banking sector is likely to stop common equity dividend payments (barring a severe recession or a Fed mandate), which would happen before preferred dividends would be at risk.
Finally, given the rise in interest rates so far this year, preferred equity issuance has been extremely limited. Well below $10bn in new supply has hit the market this year. Last year, total issuance was around $45bn. This limited supply should provide a technical support to prices.
The risk, of course, is that preferred equities could continue to fall if the economic environment deteriorates beyond the mild recession that seems to be reflected in current prices or if equity and high-yield market volatility remains elevated. However, we think that for a one-year time horizon or longer, the entry point is tilting the odds in investor’s favor.
Investment Takeaways: Perception vs. reality
While the June inflation report has dominated headlines this week, it is also important for investors to maintain a longer-run mindset. The outlook may seem bleak now, but most tend to be overly pessimistic about the future of stocks no matter what.
The New York Fed conducts a survey of U.S. consumers that asks if they expect stock prices to be higher a year from now. On average, over the past eight years, only four out of every 10 respondents thought so. However, the reality based on historical S&P 500 is that the likelihood of achieving a positive return over a one-year time horizon is 80%, roughly double that of consumer perception.
Blind optimism can hurt portfolio performance in the short-term, but allowing pessimism to derail your long-term plan can be even more detrimental to reaching your goals.
All market and economic data as of July 15, 2022 and sourced from Bloomberg and FactSet unless otherwise stated.
Preferred investments share characteristics of both stocks and bonds. Preferred securities are typically long dated securities with call protection that fall in between debt and equity in the capital structure. Preferred securities carry various risks and considerations which include: concentration risk; interest rate risk; lower credit ratings than individual bonds; a lower claim to assets than a firm's individual bonds; higher yields due to these risk characteristics; and “callable” implications meaning the issuing company may redeem the stock at a certain price after a certain date.
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