Preferred securities: seeking to reduce risk with active management

Preferred securities, possessing attributes of both fixed income and equity, are an asset class with a unique risk profile. Preferreds have preferential treatment relative to traditional equity securities, including priority over common shareholders when it comes to dividend payments or in the event of a liquidation of company assets.

Relative to fixed-income investments, preferred securities fall below traditional bonds within a company’s capital structure and, in turn, offer higher yields. These securities are typically issued by large and highly regulated institutions with solid balance sheets and investment-grade ratings, which might help limit the risk of default.

When considering an allocation to preferred securities, understanding their risk profile relative to traditional stock and bond investments is important. Taking an active approach to this asset class can provide additional opportunities for investors to manage the various types of risk found within the preferred securities market.

Sector concentration in passive strategies

One major risk inherent to passive preferred strategies is the sector concentration typically found within these investments. Often lacking diversification, these passive portfolios are heavily concentrated in just a few sectors, with the financials sector making up the bulk of these portfolios.

For an illustration of why this can be a significant risk, we can look back to the financial crisis as an example of what this sector concentration can lead to. From December 2007 through June 2009, the Intercontinental Exchange Bank of America U.S. Capital Securities Index fell by 20.9%, dragged down by the benchmark’s heavy allocation to bank issuers.

Since then, issuers of preferred securities have become more diverse, with greater representation from the utilities, energy, and consumer sectors. Even so, the preferred market still faces a lack of diversification, with passive portfolios concentrated in just a few sectors. 

Opting for an actively managed preferred securities strategy that can diverge from the benchmark offers the potential for greater diversification, reducing the concentration risk that is typically found within passive portfolios.

Finding relative value opportunities

The current banking crisis stressing markets presents a fresh risk to preferred investors since, as shown above, the banking industry alone makes up nearly half of the index. Looking ahead, we anticipate that other smaller or lower-quality banks could face potential downgrades in their credit ratings; however, the sell-off might also present a buying opportunity among higher-quality banks, with some of these institutions now seeing significant inflows that will aid their financial positions.

This divergence between companies within the same sector provides an example of how active preferred strategies can benefit from the ability to find relative value opportunities. By allowing fundamental analysis to drive security selection, the team can buy or add to holdings that it believes have the potential to outperform and shift away from those that appear to be risky or overvalued.

This concept can also apply to sector allocations, as valuations see significant deviation from their average historical value over time. These deviations present potential entry and exit points for portfolio management teams that can take advantage of these dislocations. The equity utility sector provides an example of how these relative valuations can shift over time.

Recently, the sector was trading at a greater than 40% discount to the S&P 500 Index. In mid-2021, investor sentiment around this area of the market shifted. Utility sector valuations rebounded, shooting to a 30-year high relative to the S&P 500 Index and currently remain above their average valuation. These significant deviations from historical valuations create buying and selling opportunities that have the potential to add significant alpha over time.

Shifting duration with an active preferred strategy

Like traditional fixed-income securities, preferred securities are sensitive to the path of interest rates.  Generally, preferred securities tend to have a lower duration than that of the broad fixed-income market, helping to insulate this asset class when rates are rising. Active management can go one step further, purposefully shifting the duration of the portfolio to match the portfolio team’s outlook for the interest-rate environment.

In a rising-rate environment, an actively managed portfolio can be tilted toward floating-rate securities to lower duration. One way to do this would be to buy institutional preferreds, an area that is predominated by fixed-to-floating rate securities, which offer a floating-rate coupon after their initial call date. 

These securities tend to exhibit price stability in a rising-rate environment, providing protection to any portfolios that include them. While it’s difficult to build an entire portfolio of floating-rate preferreds, as many of these securities are called by their issuers, tilting the portfolio toward these types of securities can help to mitigate the effects of higher rates.

Adding duration with fixed-rate preferreds

In a flat or falling interest-rate environment, the portfolio management team could instead extend the duration of the portfolio, allocating toward higher duration fixed-rate securities. These securities, particularly those trading at steep discounts, have the potential to perform well in a declining rate environment.

As falling rates are likely to coincide with a recessionary period, extending duration is only one of many tools that can be used to defensively position a portfolio against a souring macroeconomic backdrop. An actively managed strategy can also increase the average credit quality of a portfolio to defend against credit spread widening that might occur during an economic slowdown. Another option would be to allocate more of a portfolio toward defensive sectors such as utilities, an area that has historically offered downside protection in uncertain or recessionary economic environments. 

An additional layer of risk management

As yields continue to rise against the backdrop of a stormy economic outlook, preferred securities can offer investors an attractive stream of income without sacrificing quality. In addition, many preferred securities are qualified dividend income eligible, making after-tax yields look even better relative to other pockets of the market. We believe that taking an active approach to this asset class can provide an additional layer of risk management, helping to avoid concentration risk and giving portfolios the flexibility needed to adjust to the ever-changing market environment.