Preferred Securities - January 2012 Review & Outlook
Cohen & Steers
February 21, 2012
We would like to share with you our review and outlook for the preferred securities market as of January 31, 2012. For the month, the BofA Merrill Lynch Fixed Rate Preferred Index and the BofA Merrill Lynch Capital Securities Index each had a total return of +4.0%.
Preferred securities had their best month in more than a year in January, driven largely by significant improvement in European credit markets. Investors also gained encouragement from positive U.S. economic data, as well as improving credit trends for U.S. banks despite their lackluster profitability.
In Europe, yields on bank and sovereign debt declined sharply in the wake of the European Central Bank’s long-term refinancing operation (LTRO). The program reduced systemic risk in the financial system by improving European banks’ liquidity, while also giving banks the capacity to buy sovereign debt. In addition, negotiators made progress toward restructuring Greek debt with private creditors. Together, these developments turned the previously negative feedback loop into a positive one, and investors’ appetite for risk increased.
Beaten-down issues returned to favor
As investor sentiment improved across the board, segments of the market that did poorly in the second half of 2011 generally outperformed in January. Preferreds issued by European banks were among the leaders, with some issues achieving double-digit returns. Many adjustable-rate preferreds also had strong gains, coming off deeply discounted valuations in December.
Financial-sector preferreds had generally solid returns, particularly below-investment-grade issues. For example, preferreds issued by Bank of America and its subsidiaries rose sharply as the company reported better-than-expected improvement in capital and credit quality. Trust preferreds continued to be directly affected by financial regulatory reform: the ability of U.S. banks to call securities following an event that changes the preferreds’ capital treatment lifted certain issues toward par, but put a ceiling on those already trading above par.
Non-financial sectors underperformed after a very strong 2011. Due to their lack of credit exposure to Europe and generally higher-quality balance sheets, these issues were more defensive and suffered less in recent months. Consequently, they benefited less from the rally in riskier assets. The utility sector had modest gains, while many REIT and telecommunications preferreds declined in value.
Banks began issuing new securities ahead of regulatory announcements
In 2011, banks largely refrained from issuing preferred securities, awaiting better market conditions and clarity from regulators as to which structures would qualify as Tier 1 capital. In January, however, several banks issued new types of capital securities in an effort to preempt the wave of new issuance expected once the Federal Reserve and the Basel Committee make their announcements. Domestically, U.S. Bancorp, First Republic Bank and Schwab issued new perpetual preferred securities, for instance. In an interesting twist, one of these securities issued abroad, by Banco do Brasil, included language that would bring into force certain new attributes necessary for Basel compliance should they be required. Showing investors’ appetite, the new securities issued in January generally had strong gains following their issuance.
With Treasury yields at or near historic lows and the Federal Reserve now likely to hold interest rates steady until 2014, the high income offered by preferreds is likely to become increasingly attractive, potentially resulting in good investor demand. In addition, the high income these securities generate is likely to factor meaningfully into their total return, dampening volatility.
Given the continuing uncertainties in the global economy, our portfolio remains more heavily weighted towards domestic issuers and is generally conservative relative to credit. However, improvements in the U.S. economy combined with positive developments in Europe have somewhat brightened the outlook for risk assets. As a result, we continue to opportunistically add to certain European issues and higher-beta securities that we feel offer good risk-adjusted return profiles. That said, we remain vigilant to the potential risks, as the political and economic issues in Europe are complex and will take considerable time to resolve.
In the U.S., REIT preferreds offer high income and generally attractive metrics, including lower leverage and decent cash flow growth. We also continue to like telecom and pipeline issuer preferreds. In the financials space, we view certain U.S. regional bank preferreds as more attractive and less volatile than those of the money center banks. We also have a generally favorable view of insurance company credit fundamentals, with a preference for P&C over life companies.
(c) Cohen & Steers