Preferred securities: finding an attractive entry point ahead of a Fed pivot
Soaring inflation over the past year has compelled the Fed to respond with a series of interest-rate hikes, putting pressure on fixed-income markets, including preferred securities. Looking ahead, higher rates are likely to slow economic growth and could possibly push the U.S. economy into recession. When the Fed does pivot to a more accommodative monetary policy, we believe preferred securities have the potential for a strong rebound, making current valuations look like an attractive entry point for income seekers.
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%.
Rising rates hit fixed-income performance
Source: Bloomberg, as of 12/31/22. U.S. high-yield bonds are represented by the ICE BofA U.S. High Yield Index; U.S. Treasuries are represented by the ICE BofA U.S. Treasury & Agency Index; preferred securities are represented by the ICE BofA U.S. All Capital Securities Index; U.S. investment-grade (IG) corporate bonds are represented by the ICE BofA U.S. Corporate Index. It is not possible to invest directly in an index. Past performance does not guarantee future results.
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.
Preferreds have tended to perform well during economic recessions
Performance (Rebased to 100 as of 12/31/99)
Source: Bloomberg, National Bureau of Economic Research (NBER), monthly data as of 12/31/22. The preferred securities market is represented by the ICE BofA U.S. Capital Securities Index for the performance period of 2000 to 2012 as the index has a shorter history, starting from April 2012. U.S. recession periods, shown by the gray areas in the chart, show the latest three recession periods declared by NBER.
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.
Preferred securities have historically held up well in inflationary periods without taking on significant credit risk
Average monthly return when U.S. CPI >2%, 2002–2022
Source: Manulife Investment Management, Bloomberg, as of 12/31/22, excluding the financial crisis from September 2007 to November 2009. Performance is total return in U.S. dollars. U.S. high-yield bonds are represented by the ICE BofA U.S. High Yield Index; preferred securities are represented by the ICE BofA U.S. All Capital Securities Index; U.S. investment-grade bonds are represented by the ICE BofA U.S. Corporate Index; U.S. Treasuries are represented by the ICE BofA U.S. Treasury & Agency Index; global aggregate bonds are represented by the Bloomberg Global Aggregate Bond Index. It is not possible to invest directly in an index. For illustrative purposes only. Past performance does not guarantee future results.
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.
Index definitions
Bloomberg Global Aggregate Bond Index
The Bloomberg Global Aggregate Bond Index tracks the performance of global investment-grade debt in fixed-rate treasury, government-related, corporate, and securitized bond markets.
ICE BofA U.S. All Capital Securities Index
Intercontinental Exchange (ICE) Bank of America (BofA) U.S. All Capital Securities Index tracks all fixed- to floating-rate, perpetual callable and capital securities of the ICE BofA U.S. Corporate Index.
ICE BofA U.S. Capital Securities Index
The ICE BofA U.S. Capital Securities Index is a subset of the ICE BofA U.S. Corporate Index, including securities with deferrable coupons.
ICE BofA U.S. Corporate Index
The ICE BofA U.S. Corporate Index tracks the performance of U.S. dollar-denominated investment-grade corporate debt publicly issued in the U.S. domestic market.
ICE BofA U.S. High Yield Index
The ICE BofA U.S. High Yield Index tracks the performance of below-investment-grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market and includes issues with a credit rating of BBB or below.
ICE BofA U.S. Treasury & Agency Index
The ICE BofA U.S. Treasury & Agency Index tracks the performance of U.S. dollar-denominated U.S. Treasury and nonsubordinated U.S. agency debt issued in the U.S. domestic market.
It is not possible to invest directly in an index.
Important disclosures
This material is for informational purposes only and is not intended to be, nor shall it be interpreted or construed as, a recommendation or providing advice, impartial or otherwise. John Hancock Investment Management and our representatives and affiliates may receive compensation derived from the sale of and/or from any investment made in our products and services.
The views presented are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. Past performance does not guarantee future results.
Ratings are from Moody’s, if available, and from Standard & Poor's or Fitch, respectively, if not. When not available, internal ratings provided by the subadvisor are used. Ratings composition will change. Individual bonds are rated by the creditworthiness of their issuers; these ratings do not apply to the fund or its shares. U.S. government and agency obligations are backed by the full faith and credit of the U.S. government. All other bonds are rated on a scale from AAA (extremely strong financial security characteristics) down to CCC and below (having a very high degree of speculative characteristics). “Short-term investments and other,” if applicable, may include fund receivables, payables, and certain derivatives.
Diversification does not guarantee a profit or eliminate the risk of a loss. Duration measures the sensitivity of the price of bonds to a change in interest rates.
Fixed-income investments are subject to interest-rate and credit risk; their value will normally decline as interest rates rise or if an issuer is unable or unwilling to make principal or interest payments. Preferred stock dividends are payable only if declared by the issuer’s board. Preferred stock may be subject to redemption provisions. Investments in higher-yielding, lower-rated securities involve additional risks as these securities include a higher risk of default and loss of principal. Currency transactions are affected by fluctuations in exchange rates, which may adversely affect the U.S. dollar value of a fund’s investments. Liquidity—the extent to which a security may be sold or a derivative position closed without negatively affecting its market value, if at all—may be impaired by reduced trading volume, heightened volatility, rising interest rates, and other market conditions.
The subadvisors’ affiliates, employees, and clients may hold or trade the securities mentioned, if any, in this commentary. The information is based on sources believed to be reliable, but does not necessarily reflect the views or opinions of John Hancock Investment Management.