Preferred securities: finding an attractive entry point ahead of a Fed pivot

Several factors have led to skyrocketing levels of inflation over the past year, including heightened oil and natural gas prices that are due, in part, to the war in Ukraine and the disruption of Russian energy exports. Pent-up demand after the COVID lockdowns coupled with supply chain issues has also helped to create sharp price increases for many goods and services. With inflation reaching levels not seen in four decades, the U.S. Federal Reserve (Fed) took aggressive action, embarking on a series of interest-rate hikes over the course of 2022.

Due to the inverse relationship between yields and bond prices, rising rates made for a very difficult year for fixed-income investors. Through the end of December, U.S. high-yield bonds fell by 11.2% while U.S. investment grade (IG) corporate bonds fell by 15.4%.

Do rising interest rates affect preferred securities?

Preferred securities have fared slightly better than IG corporate bonds, falling by just under 15% over the same time period. This relative outperformance can be attributed to the high-quality nature of preferreds, with an average credit quality of BBB, in addition to their relatively low duration and, consequently, lower interest-rate sensitivity. These features could also mean that preferred securities are well positioned for the market ahead, even if the U.S. economy tips into a recession.

Preferreds’ performance in recessionary periods

Historically, preferred securities have tended to hold up fairly well during recessionary periods, with the exception of the period from December 2007 to June 2009, when the U.S. banking sector was profoundly affected by the subprime mortgage crisis. With the preferred market heavily skewed toward bank issuers at that time, this helps explain why preferred securities experienced a significant drawdown during the global financial crisis. 

Looking ahead to the possibility of another recession, the preferred market is constructed quite differently today than it was during the financial crisis; preferred issuers are now more diverse. Although financial services still make up a sizable portion of the overall preferred market, we now have more issues in the utilities, energy, and even consumer sectors. Banking is now also subject to heavier regulation than it had been prior to the financial crisis, putting companies in this segment in a significantly stronger position from a balance sheet perspective. Recent earnings show that banks remain well capitalized and able to withstand a range of credit issues that could come up if the market environment turns negative.

Preferreds’ performance in inflationary periods

The preferred market has also tended to perform well in inflationary periods, outperforming nearly all other sectors of the fixed-income market with the exception of high yield. Some preferred securities have a floating-rate feature that enables the coupon to reset on a quarterly basis, which allows them to exhibit a higher degree of price stability in a rising rate environment. 

Although high-yield bonds have outperformed preferreds during inflationary periods, the average high-yield credit rating of B means that this asset class comes with more credit risk than preferred securities, which have an average credit rating of BBB. Should an inflationary environment coincide with a recession, we believe that preferred securities could be relatively better insulated due to their unique capacity to perform well in either market environment.

If the Fed does pivot—pausing or even cutting rates in 2023—this would be beneficial for the asset class. With less potential for credit spread widening due to their higher credit quality, this would be a positive backdrop for preferreds.

Current opportunities within preferred securities

Although we have a positive outlook for preferred securities as an asset class, there are also pockets of opportunity in which active managers can demonstrate an advantage.

The utilities sector is one area that seems ripe with opportunity, especially if a recession were to occur. Within the United States, utilities are a defensive investment due to their regulated nature. This helps to create a consistent earnings and cash flow profile that remains stable despite changes in the economic environment. Companies in this sector are leading the transition to renewable energy in the United States, something that regulators consider favorably. These approved investments in renewable energy help to further amplify earnings and cash flow for utilities companies since they earn a regulated rate of 9.5% to 10.0% on their investments.

We also have a positive view of financials as companies in this sector have strong balance sheets—better, in fact, than we’ve seen for 50 years. As mentioned earlier, the most recent earnings reported by banks remain strong and show that they remain well capitalized, easily able to absorb credit losses that may arise. Insurance companies look well positioned, too; as with utilities, insurance is a highly regulated industry. Higher interest rates tend to benefit these companies as higher rates tend to help them earn higher returns on their investment portfolios.

The fundamentals for the energy space also look good, particularly for natural gas pipeline companies that aren’t dependent on commodity prices. Natural gas demand continues to grow, driven by more electricity generation and steady demand; however, we’re keeping an eye on oil prices, as the higher they rise, the risk of recession rises accordingly.

Positioned for a Fed pause or pivot

Although preferred securities haven’t been immune to the negative price pressure experienced by fixed-income markets, we expect to see a robust rebound if the Fed pivots policy. Active management that can tilt a portfolio toward sectors with strong fundamentals while tactically adjusting portfolio duration to align with the projected path of interest rates could have an advantage, with these portfolios nimbly navigating today’s volatile and shifting market conditions.