Preferred Securities Review & Outlook for April 2012
Cohen & Steers
May 18, 2012
Review & Outlook for April 2012
We would like to share with you our review and outlook for the preferred securities market as of April 30, 2012. For the month, the BofA Merrill Lynch Fixed Rate Preferred Index had a total return of +0.5% and the BofA Merrill Lynch Capital Securities Index returned +0.2%. Year to date, the indexes had total returns of +7.3% and +8.4%, respectively.
Preferred securities had a modestly positive total return in April. Fixed income issues broadly outperformed equities in the month amid softer U.S. economic data, renewed European sovereign risk concerns and declining Treasury yields. Year to date, preferreds maintained their outperformance of most fixed income classes; demand for above-average income has underpinned the group’s performance in an environment of slow growth and historically low interest rates. As well, steady improvements in bank credit fundamentals, such as those revealed by earnings reports in April, have supported higher prices.
Preferreds issued by European companies generally had a flat return in the month following a strong first quarter. These so-called Yankee preferreds were restrained by political uncertainty in France and the Netherlands, along with deteriorating economic conditions throughout much of the region, particularly in southern countries.
From a sector standpoint, most groups had modest but positive returns. Preferreds issued by banks generally benefited as operating results continued to show improvements in credit metrics. Although revenue and earnings growth remained tepid, there was a general improvement in banks’ trading operations in the wake of robust first-quarter capital markets. In the insurance sector, property & casualty companies had mostly good earnings following several months of relatively favorable weather. Life insurance issuers had more mixed results, in part due to the damping effects that low interest rates have had on investment returns.
Preferreds issued by REITs modestly outperformed the index, aided somewhat by their U.S.-centric nature as investors became more concerned about Europe. Real estate companies continued to refinance callable preferreds with new issues, with coupons as low as 6% (which is still meaningfully higher than yields on investment-grade bonds).
Barring meaningful erosion in the economic backdrop, we believe preferreds can continue to deliver attractive total returns due to generally improving credit fundamentals and historically wide credit spreads. In addition, favorable technicals should continue to support the asset class, as investor appetite for income is likely to remain strong and the overall size of the market could shrink as banks retire issues that may lose Tier 1 capital status. Preferreds offer an average yield close to 7%, which is significantly higher than other investment-grade alternatives such as corporate bonds and Treasurys.
In terms of sector allocation, we have increased our weight in the banking sector in recent months, taking advantage of the dip in prices that occurred over the second half of last year. We view certain U.S. regional bank preferreds as more attractive and generally less volatile than those of the capital markets-oriented banks. In addition, we have found good value in several newer issues that have also helped reduce call and reinvestment risk in the portfolio. That said, the banking sector makes up a large proportion of the market, and we are underweight, principally via a more conservative stance towards European banking issues.
Looking at other sectors, while we have reduced our allocation to REITs, we remain overweight. These companies have continued to demonstrate strong access to capital and steady improvements in their balance sheets and cash flows. In addition, we favor telecom and pipeline preferreds and also value the diversification benefits of these sectors. We have a generally positive view of insurance company credit fundamentals, with a preference for property and casualty insurance companies over life insurers, given the earnings pressures the latter face amid low interest rates. We have identified attractive values in new insurance preferreds as well, with several recent offerings out of companies from Bermuda to Japan to Switzerland.
(c) Cohen & Steers