When Interest Rates Rise

Transcription

1 Preferred Securities When Interest Rates Rise William Scapell, CFA, Director of Fixed Income and Portfolio Manager Jerry Dorost, CFA, Vice President and Research Analyst Edited by David Shanahan With the interest-rate environment becoming less accommodative, what will happen to preferred securities? We believe the answer is that some securities will perform much better than others. This was certainly the case in 2013, which we use as a case study to examine different aspects of the preferred securities market. As active managers, we seek structures, income rates and credit spreads that can help protect investors when rates rise. Highlights A preferred security s structure is often the biggest driver of interest-rate sensitivity, with lower-duration fixed-to-float securities generally being less vulnerable to changes in interest rates, or yields. Preferred securities continue to generate some of the highest yields within the investment-grade fixed income universe, providing a defense against rising interest rates. Wide credit spreads can cushion the effects of rising Treasury yields, as improving fundamentals of financial issuers can lead to spread narrowing. A professional asset manager with access to the global preferred securities market can manage portfolio interest-rate risk by diversifying into other markets with differing interest-rate cycles. Advisors & Investors: Institutions & Consultants:

2 When Interest Rates Rise 2 Case Study Overview 3 Preferreds and Rising Rates 4 Credit Considerations 5 Effect of Security Structures 7 Conclusion Case Study Overview Rising Yields in 2013 May Offer Clues as to What s Ahead What will happen to preferreds when interest rates rise? We think 2013 was very informative. As the year progressed, officials at the Federal Reserve began to talk of tapering monthly bond purchases. Fixed income markets reacted negatively, with the 10-year U.S. Treasury benchmark vaulting from 1.65% in late April to 3.0% by year end. For preferred securities, 2013 was a tale of two markets. The BofA Merrill Lynch Fixed Rate Preferred Securities Index, which captures investment-grade exchange-listed preferred securities, returned -3.7% for the year, whereas the BofA Merrill Lynch Capital Securities Index, which represents institutional over-the-counter (OTC) preferred securities, posted a total return of 4.9% more than eight percent higher. What caused this gaping difference? Structure was perhaps the biggest driver, as most OTC issues are built to be far less rate sensitive. The OTC index is dominated by fixed-to-float securities. Instead of a coupon that is fixed in perpetuity, these issues offer a period of fixed payments followed by a period of floating-rate payments. Interest-rate risk is not obviated by this structure, but it can be reduced significantly. Income is another form of defense against interest rates, and preferreds continue to generate some of the highest income within the investment-grade fixed-income universe. Importantly, since total return is a combination of income and price return, the significant income advantage of preferreds provides a cushion that enhances returns and dampens total-return volatility over time. Wide credit spreads can also act as a shock absorber to rising Treasury yields. We observed this trend in 2013, when a narrowing in credit spreads helped preferred securities outperform corporates, Treasuries and other areas of fixed income. Below-investment-grade issues with wide spreads generally fared best, as their spreads had the most room to contract. Given the rapidly improving fundamentals of the financial issuers that dominate the preferred securities market, we see opportunity for further spread compression ahead. As professional managers who invest globally, we can also alter portfolio interest-rate risk by investing in preferreds denominated in foreign currencies. These will react to the rate environment governing the foreign currencies rather than to factors influencing U.S. Treasuries. In this regard, we point to Europe, where the European Central Bank is still in the early stages of quantitative easing measures, moving in the opposite direction from U.S. monetary policy. The factors above do not fully mitigate the risk of rising rates. However, along with active management, we believe they can help to protect investors. 2

3 Preferreds and Rising Rates A Look at Outperformance in 2013 Taken as a whole, preferred securities including both OTC and exchange-traded market components generally outperformed other fixed income assets in 2013, as shown in Exhibit 1 below. Important drivers of this performance were high income, wide credit spreads and lower-duration security structures. This report explores each of these drivers in more detail and drills down on preferred market segments to better understand sources of performance. Highlighted below is the importance of income to total returns. The income advantage of preferred securities is one reason that the asset class has historically delivered more consistent returns over time than many other fixed income investments. It is important to remember that price returns do not account for the potential income and reinvestment that could buoy total return over time. To illustrate, in 2013, investment-grade preferreds had an average annual yield of 6.2%, substantially more than investment-grade corporate bonds. So although prices of the blended investment-grade preferred index declined 5.6%, the addition of 6.2% annualized income resulted in a positive total return of 0.6%. An environment of rising interest rates (or yields) could cause the prices of existing investments to drop, but the loss would be at least partially offset over time through coupon payments and higheryielding reinvestment opportunities. In 2013, the high income of preferred securities helped buoy total return at a time when lower-yielding investment-grade asset classes struggled. Exhibit 1: The Importance of Income to Total Return Asset Class Performance in 2013 Price Change Income Total Return 10% 5% 0% % -10% Preferred Securities (a) Corporate Bonds (b) Municipal Bonds (c) 10-Year Treasury TIPS (d) Source: Cohen & Steers, BofA Merrill Lynch. Performance data quoted represents past performance. Past performance is no guarantee of future results. (a) 50/50 blend of BofA Merrill Lynch Capital Securities Index and BofA Merrill Lynch Fixed Rate Preferred Securities Index. (b) BofA Merrill Lynch Corporate Master Index. (c) BofA Merrill Lynch Municipal Master Index. (d) BofA Merrill Lynch U.S. Inflation-Linked Treasury Index. See page 8 for index definitions and additional disclosures. 3

4 When Interest Rates Rise Credit Considerations Wide Credit Spreads Can Help Defend Against Rising Rates Since the financial crisis, we have observed that preferred securities have become much more credit sensitive. One reason for this is that the asset class is heavily dominated by financial issuers particularly banks and insurance companies which receive beneficial regulatory capital treatment from issuing preferred securities. As highlighted below, the credit spreads of these issues, which widened materially during the financial crisis, have remained disproportionately wide relative to historical pre-crisis levels. These wide spreads have persisted despite drastic improvements in issuers credit quality, spurred largely by far stricter regulatory requirements that improve capital and reduce operating risks. Today, preferred securities offer 320 basis points (bps) more in income than 10-year Treasuries, compared with the longer-term pre-crisis average spread of 227 bps. Exhibit 2: Preferred Securities vs. 10-Year Treasury History January 1997 Through November 30, 2015 Preferred Securities (credit quality: BBB) (a) 10-Year Treasury 16% 12% Pre-Credit-Crisis Average Spread ( 97 07) (b) : 227 bps Yield 8% 4% Wide yield spreads may diminish interest-rate risk (c) 5.4% Current Spread 320 bps 2.2% At November 30, Source: Bloomberg. Note: Yields shown on a yield-to-maturity basis. Performance data quoted represents past performance. Past performance is no guarantee of future results. (a) BofA Merrill Lynch Fixed Rate Preferred Securities Index. (b) Index rating was single-a pre-crisis compared with BBB today. (c) Treasury yields may rise in the future, and that could have a negative spillover effect on other fixed income securities with relatively narrow spreads over Treasuries. As shown in the chart, the spread between preferred securities and Treasuries is well above the pre-credit-crisis average. Preferred securities wide spreads to Treasuries may cushion the impact of a rising-rate environment. See page 8 for index definitions and additional disclosures. Wide credit spreads are a first line of defense against rising interest rates and the wider the credit spread, the stronger the defense potential. Since credit risk has historically diminished in an improving economic climate, wide spreads can help cushion returns as this spread contraction helps to offset some or all of the higher Treasury yields. Potentially, the demanded yield on the credit instrument may not rise as much as that of a Treasury benchmark. It is worth pointing out that spread compression does not always occur, or it may occur over time or in an uneven fashion. For example, in 2013, outflows from preferred exchange-traded funds (ETFs), as well as tax-loss selling, kept pressure on the investment-grade exchange-traded market in the second half of the year. These outflows prevented spreads from narrowing as Treasury yields rose. In this case, market technicals overpowered the impact of steady fundamental issuer improvements. 4

5 The picture was a bit different in below-investment-grade preferreds, in both the exchange-traded and OTC markets. The wide spreads these securities offered did compress in the second half of 2013, providing something of a cushion. As a result, these securities provided better relative price returns than investment-grade preferreds in 2013, shown in Exhibit 3. Below-investment-grade OTC preferreds generated an average total return of 14.3%, 935 bps higher than that of investment-grade OTC preferreds. Similarly, below-investment-grade exchange-listed preferreds generated a 2.7% total return, 639 bps more than comparable investment-grade preferreds. We note again that spread compression does not always occur, but it can be powerful. Exhibit 3: Preferred Securities Performance in 2013 Exchange-Traded (a) Over-the-Counter (b) Spread narrowing had a greater impact on lowerquality preferreds in 2013, driving stronger returns. 20% 15% 10% 5% 0% % -3.7 Investment Grade Below Investment Grade Source: Bloomberg. Performance data quoted represents past performance. Past performance is no guarantee of future results. (a) BofA Merrill Lynch Fixed Rate Preferred Securities Index. (b) BofA Merrill Lynch Capital Securities Index. See page 8 for index definitions and additional disclosures. Effect of Security Structures The Composition of Exchange-Listed and OTC Markets Can Affect Interest-Rate Sensitivity There are two distinct trading markets for preferred securities: the retail exchange-traded market and the institutional OTC market. Many securities in the OTC market have a fixed-to-float structure through which payments begin at a fixed rate for a specified period (often 10 years) and then convert to a floating rate that typically resets every quarter at a pre-defined rate above a benchmark such as LIBOR. (1) Since the rate can reset in the future, fixed-to-float issues have the potential to offer relatively modest interestrate risk. The durations of such issues duration being a measure of price sensitivity with respect to changing yields is based almost entirely on the length of the fixed-rate payment period. By contrast, many exchange-traded preferred securities offer a fixed-payment rate in perpetuity and thus carry very high durations and price sensitivities relative to changes in demanded rates. For a more detailed explanation of these security structures, see Examples of Preferred Structures on page 7. Some preferred securities offer superior risk-reward characteristics based on structure and credit spreads. (1) LIBOR is the London Interbank Offered Rate. 5

6 When Interest Rates Rise The impact of duration was evident in 2013, when the global preferred securities market delivered a positive total return and outperformed other investment-grade fixed income asset classes. Although the exchange-traded preferred market had a negative return for the year, the OTC market gained 4.9%. A very important difference is that the OTC index is largely composed of fixed-to-floating-rate securities, whereas the exchange-listed market is primarily a fixed-rate market. We do note, however, that there has been a growing opportunity to own fixed-to-float securities in the exchange-listed market as well. As of November 2015, the duration on the OTC preferred index was 5.6 years, about the same as exchange-traded preferreds, but lower than corporate bonds (6.7 years) and 10-year U.S. Treasuries (8.9 years). Perhaps just as important is that the durations of many OTC preferred securities do not extend as they do with most exchange-traded preferred securities. So a duration of 5.6 years would be accurate whether the security is priced at a premium or below par. Conversely, duration measures of exchangetraded fixed-for-life preferreds can be misleading; duration could extend if the market environment changes and it is no longer advantageous for that issuer to redeem the security at its first call date. In 2013, the OTC market for preferred securities outperformed the exchange-traded market by 860 basis points. The dispersion in returns both in 2013, when Treasury yields were rising, and in 2014, when yields were falling reflects the higher inherent volatility profile of the exchange-traded preferred market. In our view, investors may be best served by focusing on the better risk-adjusted returns and larger investment universe offered in the OTC market. Even better, investors could take a tactical approach to owning the best securities in both markets, as we do. Exhibit 4: Preferred Securities A Tale of Two Markets Preferred Securities Other Fixed Income 50/50 Blend Institutional/ Retail (a) Institutional (Over-the- Counter) (b) Retail (Exchange- Traded) (c) Total Return 10-Year Treasury Yield Trend Corporate Bonds (d) Municipal Bonds (e) 10-Year Treasury TIPS (f) High-Yield Bonds (g) 2015 YTD Sideways 4.3% 1.6% 7.0% 0.2% 2.7% 1.2% -0.9% -2.1% 2014 Falling 12.2% 8.9% 15.4% 7.5% 9.8% 10.7% 4.5% 2.5% 2013 Rising 0.6% 4.9% -3.7% -1.5% -2.9% -7.8% -9.4% 7.4% Modified Duration at 11/30/15 (years) (h) At November 30, Source: Cohen & Steers and BofA Merrill Lynch. Performance data quoted represents past performance. Past performance is no guarantee of future results. (a) 50/50 blend of BofA Merrill Lynch Capital Securities Index and BofA Merrill Lynch Fixed Rate Preferred Securities Index. (b) BofA Merrill Lynch Capital Securities Index. (c) BofA Merrill Lynch Fixed Rate Preferred Securities Index. (d) BofA Merrill Lynch Corporate Master Index. (e) BofA Merrill Lynch Municipal Master Index. (f) BofA Merrill Lynch U.S. Inflation-Linked Treasury Index. (g) BofA Merrill Lynch High Yield Master Index. (h) Modified duration measures the effect that a 100 bp change in interest rates will have on the price of a bond. See page 8 for index definitions and additional disclosures. 6

7 Examples of Preferred Structures Fixed-Rate Securities Typically, exchange-traded perpetual preferred securities offer a fixed rate of income in perpetuity. Due to the potential for credit-spread tightening, the demanded yield on the security will not necessarily move in tandem with Treasury yields. But price sensitivity to rising rates tends to be quite high. Retail (Exchange-Traded) Wells Fargo 6% coupon, fixed rate in perpetuity, callable in 2020 at par Call Duration: 14.1 Fixed-to-Floating-Rate Securities These issues make fixed-rate payments for a specified period of time most typically 10 years after which they can be redeemed or switched to a floating rate. Since payments reset with the rate environment, the floating-rate portion offers near-zero interest-rate risk. As a result, the security acts like a much shorter-term issue, with a far lower duration. Institutional (OTC) Wells Fargo 5.875% fixed coupon until call date in 2025, coupon reset quarterly to 3-month LIBOR % if not called in 2025 at par Call Duration: 7.2 Floating-Rate Securities Payments for floating-rate issues are usually benchmarked to a short-term benchmark, such as LIBOR, though some securities will pay a spread over longer-term benchmarks such as the 10-year Treasury. Given the long-term nature of the cash flows associated with these issues, and since the income of these securities will reset with higher benchmark rates, securities of this nature may actually rise in price if markets begin to price in higher-than-expected rates in the future. Institutional (OTC) ING floating-rate perpetual, coupon reset quarterly at 3-month LIBOR + 3.6% 2015 Duration: ~0.2 Conclusion Managing Interest-Rate Risk As we learned from the rising-rate period in 2013, preferred securities are not all alike, and some can vastly outperform others when these conditions reappear. Diversification is important, but we believe the key to taking advantage of the higher income that preferred securities offer today and navigating the potential for higher rates ahead is active management, backed by in-depth research focused on credit and structure selection. Some of the tools and strategies we find useful are summarized below. High coupons and wide credit spreads. In both the OTC and exchange-listed markets, we are focused on securities that not only offer relatively high income rates and aboveaverage spreads, but also have a fair amount of time before they can be called, as we expect that longer-term interest rates will remain relatively low. While we are more cautious in some areas, we also see specific credit catalysts driven by regulatory changes at banks and general economic improvements. A mixture of structures. The interest-rate sensitivity of a preferred security is largely the result of its structure. Fixedto-float and pure floating-rate issues are generally the least sensitive to interest rates, as their coupons reset, often frequently. But interestingly, these structures can also offer more call protection often 10 years versus the typical 5 years for fixed-rate exchange-listed preferred securities. This potentially offers less price risk should interest rates turn higher. Foreign-currency issues. Preferred securities issued in foreign currencies can help diversify interest-rate risk, as they tend to react to the yield curve of their domestic market, which is mostly a function of local economic and monetary cycles. Monetary policy in Europe, for instance, is now far more accommodative than in the U.S. Use of hedging to reduce interest-rate risk. Cohen & Steers can engage in interest-rate hedging if and when we find it desirable and/or necessary. Our in-house hedging capabilities are supported by an experienced quantitative and derivatives team, which may purchase, sell or enter into any derivative contract or option. These may include various interest-rate transactions, foreign-currency transactions and other similar transactions. While we believe it is valuable to have these hedging tools at our disposal, we approach them tactically and currently believe that the most effective method of managing interestrate risk over time is careful and active portfolio construction. 7

8 Index Definitions An investor cannot invest directly in an index, and index performance does not reflect the deduction of any fees, expenses or taxes. BofA Merrill Lynch Capital Securities Index is a subset of the BofA Merrill Lynch U.S. Corporate Index including all fixed-to-floating-rate, perpetual callable and capital securities. BofA Merrill Lynch Corporate Master Index tracks the performance of U.S. dollar-denominated investment-grade corporate debt publicly issued in the U.S. domestic market. BofA Merrill Lynch Current 10-Year U.S. Treasury Index is a one-security index composed of the most recently issued 10-year U.S. Treasury note. The index is rebalanced monthly. In order to qualify for inclusion, a 10-year note must be auctioned on or before the third business day before the last business day of the month. BofA Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of fixed-rate U.S. dollar-denominated preferred securities issued in the U.S. domestic market. BofA Merrill Lynch High Yield Master Index tracks the performance of U.S. dollar-denominated below-investment-grade corporate debt publicly issued in the U.S. domestic market. BofA Merrill Lynch Municipal Master Index tracks the performance of U.S. dollar-denominated investment-grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions, in the U.S. domestic market. BofA Merrill Lynch U.S. Inflation-Linked Treasury Index tracks the performance of U.S. Treasury Inflation Protected Securities with at least $1 billion in outstanding face value and a remaining term to maturity greater than one year. Performance data quoted represents past performance. Past performance is no guarantee of future results. The information presented in this commentary does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers and there is no guarantee that any historical trend presented in this commentary will be repeated in the future, and no way to predict precisely when such a trend will begin. There is no guarantee that any market forecast set forth in this document will be realized. The views and opinions in the preceding commentary are as of the date of publication and are subject to change without notice. This material represents an assessment of the market environment at a specific point in time, should not be relied upon as investment advice, is not intended to predict or depict performance of any investment and does not constitute a recommendation or an offer for a particular security. We consider the information in this document to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of suitability for investment. Investors should consult their own advisors with respect to their individual circumstances. Risks of Investing in Preferred Securities Investing in any market exposes investors to risks. In general, the risks of investing in preferred securities are similar to those of investing in bonds, including credit risk and interest-rate risk. As nearly all preferred securities have issuer call options, call risk, reinvestment risk and income risk are also important considerations. In addition, investors face equity-like risks, such as deferral or omission of distributions, subordination to bonds and other more senior debt, and higher corporate governance risks with limited voting rights. Preferred funds may invest in below-investment-grade securities and unrated securities judged to be below investment grade by the Advisor. Below- Investment-grade securities or equivalent unrated securities generally involve greater volatility of price and risk of loss of income and principal, and may be more susceptible to real or perceived adverse economic and competitive industry conditions than higher-grade securities. The benchmarks do not contain below-investment-grade securities. Risks associated with preferred securities differ from risks inherent with other investments. In the event of bankruptcy, a company s preferred securities are senior to common stock but subordinated to all other types of corporate debt. Corporate bonds sit higher in the capital structure and therefore, in the event of a bankruptcy, will be senior to preferred securities. High-yield bonds, although typically issued by different types of issuers than those that issue preferred securities and rated below investment grade, also would sit higher in a firm s capital structure than preferred securities if the issuer did employ both forms of issuance. 10-Year Treasury notes are issued by the U.S. government and are considered the safest of all bonds, since they are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. This commentary must be accompanied by the most recent Cohen & Steers Fund fact sheet(s) if used in connection with the sale of mutual fund shares. About Cohen & Steers Cohen & Steers is a global investment manager specializing in liquid real assets, including real estate securities, listed infrastructure, commodities and natural resource equities, as well as preferred securities and other income solutions. Founded in 1986, the firm is headquartered in New York City, with offices in London, Hong Kong, Tokyo and Seattle. Publication Date: January Copyright 2016 Cohen & Steers, Inc. All rights reserved. cohenandsteers.com Advisors & Investors: Institutions & Consultants: VP623_1215