Top of the Morning: Preferred Securities - Performance & positioning

Frank Sileo · UBS Chief Investment Office

Remains constructive on $1,000 par institutional preferreds: variable coupons, far less rate sensitivity, about 7% yields.

Institutional $1,000 par preferreds have variable-rate coupons, so they are much less sensitive to interest rates than $25 par preferreds, with duration less than half that of the $25 par sector. Yields are about 7%, compared with roughly 7.25-7.5% in the $25 par space, so investors give up a little yield for significantly less interest-rate risk. That is why these have been a primary focus of his recommendations for several years.

“I'm still very constructive on the institutional thousand dollar par preferred subsector as well. Those have variable rate coupons, so they're much less sensitive to interest rates than their $25 par counterparts.”at 1:11

Frank Sileo · UBS Chief Investment Office

Upgrades $25 par retail preferreds to attractive on tactical rebound, 7%+ yields and possible Treasury stabilization.

CIO upgraded the $25 par retail preferred sector to attractive, while he remains constructive on $1,000 par institutional preferreds. The case rests on three points: after pronounced recent underperformance a tactical rebound is possible; yields are above 7%, close to 7.25-7.5% in the $25 par space, which gives meaningful carry and a head start on total return; and Treasury yields have greater scope to stabilize after a volatile stretch (the 10-year rose 82bp in Q3 and reached 5.31% in early October, its highest since 2002). Valuations also look more attractive after the underperformance: yield premiums over the 10-year Treasury are about 15-20% above their own five-year median, with more limited downside from here. If Treasury rates trend lower, which is CIO's expectation, price appreciation would add to the carry. Overall, a potentially attractive risk-reward over the next twelve months.

“What's changed is that we now see an increasingly compelling opportunity in the $25 par preferred space.”at 1:42

Frank Sileo · UBS Chief Investment Office

Preferred duration is at a 15-year high, roughly double pre-2021 levels, making $25 par preferreds more rate-sensitive.

The 2020-21 refinancing boom, when the Fed cut rates near zero, let issuers lock in historically low coupons on fixed-rate perpetual preferreds, which changed the character of the market. Duration in the $25 par sector is now more than nine years, the highest in the nearly 15-year history of the major fixed-rate preferred index. In the five years before 2021 the average was about 4.6 years, so the market now has roughly twice the interest-rate sensitivity. That explains the recent underperformance: surging Treasury yields colliding with historically high duration.

“Today, duration in the $25 par sector... it's more than nine years. That's the highest it's been in the nearly fifteen year history of the major fixed rate preferred index.”at 4:44

Frank Sileo · UBS Chief Investment Office

Treasury yields falling in a flight to quality may not lift preferred prices; credit spreads can widen.

The usual logic is that lower Treasury yields make credit yields look more attractive, lifting credit prices, all else equal. But all else is not always equal. If Treasury yields fall because of a flight to quality, as seen in recent weeks, credit markets are not necessarily going to benefit. Investors may demand more compensation for taking credit risk, so credit spreads can widen even as Treasury yields come down. This is why preferreds declined in October even when rates were falling.

“But all else is not always equal. If treasury rates are falling because of a flight to quality like we've seen in recent weeks, credit markets aren't necessarily gonna benefit.”at 6:27

Frank Sileo · UBS Chief Investment Office

Preferred spread duration is almost three times high yield's, so preferreds widen more when spreads widen.

The refinancing boom and record-low coupons also increased credit spread sensitivity (spread duration). The $25 par sector's spread duration is more than twice its pre-2021 five-year average and almost three times that of the high yield bond market, whereas before 2021 the two were much closer. Preferreds typically yield 1.5 to 2 times the spread on the same issuer's senior bonds, compensating for subordination and the issuer's call option, since redemption timing is uncertain. That multiple works both ways: for every 10bp of senior-bond spread widening, the preferred spread may widen 15-20bp.

“But today, the spread duration of the $25 par preferred sector is almost three times that of the high yield bond market.”at 8:10

Frank Sileo · UBS Chief Investment Office

$25 par preferreds offer a wide yield pickup over investment-grade bonds, with a narrower gap to high yield.

On a trailing five-year basis, $25 par preferreds have typically yielded about 110bp more than investment-grade corporates and about 140bp less than high yield. Now the yield advantage over investment-grade corporates is closer to 160bp, while the gap versus high yield has narrowed to about 80bp. Investors are therefore getting considerably more yield relative to investment-grade corporates than usual, while the yield gap to high yield is much smaller. Combined with yield premiums over the 10-year Treasury 15-20% above their five-year median, this supports the relative-value case.

“But today, that yield advantage over investment grade corporates is higher. It's closer to a 160 basis points, while the gap versus high yield has narrowed. It's narrowed to about 80 basis points.”at 11:05

Frank Sileo · UBS Chief Investment Office

Preferred issuers are higher-quality, mostly investment-grade banks and utilities, giving the market a quality bias.

Preferreds are typically issued by higher-quality companies, particularly large money center and super-regional banks and utilities, which gives the preferred market an inherent quality bias. The preferreds themselves are subordinated in the capital structure, so their ratings are generally notched below the issuer's senior debt. However, the underlying issuers are generally investment-grade companies operating in highly regulated sectors.

“Preferreds are typically issued by higher quality companies, particularly the large money center and super regional banks as well as utilities.”at 12:43

Frank Sileo · UBS Chief Investment Office

Expects Treasury yields to stabilize and trend lower, giving preferreds a better backdrop in 2027.

Treasury yields have been extremely volatile this year. The 10-year rose 82bp in Q3, the fourth-largest quarterly increase in a decade, with much of the move in September and a peak of 5.31% in early October, the highest since April 2002. Frank argues there is greater scope for yields to stabilize from here. If rates become more stable or begin moving sustainably lower, that would be a much better backdrop for longer-duration securities such as $25 par preferreds, and he expects this in 2027. He notes CIO expects Treasury rates to trend lower, though the preferred rebound does not depend on that.

“we think there's greater scope for treasury yields to stabilize from here... if rates become more stable or begin moving sustainably lower, that should provide a much better backdrop for longer duration securities like $25 par prefers, and we do think we'll see that in 2027.”at 2:37

Frank Sileo · UBS Chief Investment Office

Does not forecast a recession, credit crunch or default spike in 2027.

The macro and credit backdrop matters for the preferred case. CIO is not forecasting a recession, credit crunch or spike in defaults in 2027. Given the yields investors receive today, the compensation for taking risk is attractive. Frank also does not expect the forces that drove rates and spreads higher in recent weeks and months to continue with the same intensity.

“We're not forecasting a recession or credit crunch or a spike in defaults in 2027.”at 12:16