Preferred securities’ 2020 trajectory—a resilient recovery
While preferred securities were affected by the global pandemic fallout, their trajectory throughout 2020 has shown this to be a resilient asset class.
After the volatility witnessed in the first quarter of 2020, preferred securities also benefited from the U.S. Federal Reserve’s supportive actions, recovering 16.27% in the second and third quarter of 2020, surpassing that of U.S. high-yield bonds, which rebounded by 15.49% during the same period. Year to date, preferred securities posted a 5.98% return while U.S. high-yield bonds gained 4.18%.¹
With potential yield spread tightening and a lower-for-longer interest-rate environment, we’re positive that preferred securities, as an investment-grade asset class, can potentially help investors navigate the low-yield landscape that will persist into the new year.
Positive macro trends
The economic environment should continue to improve in 2021. As multiple global vaccines come into play, we anticipate broad-based spread tightening—a positive catalyst for preferred securities. The average yield spread of preferred securities versus the 10-year U.S. Treasury is still above the historical average yield spread—meaning there’s potential for further spread tightening. Furthermore, this is expected to occur across sectors—consumer cyclicals and telecommunications—which has the potential for greater spread tightening as the economy improves.
We also believe that the previously mentioned lower-for-longer interest-rate environment will persist in 2021. There are three reasons to support our view. First, growth and inflation expectations are expected to be muted. GDP expansion, particularly in the United States, may also be hampered by demographic pressures, as the over-65 age group is set to increase by more than 50% in the next three decades.² Secondly, the looming prospect of a smaller fiscal stimulus stemming from a divided U.S. government may temper inflation expectations. Thirdly, there’s now a record US$17.17 trillion in negative-yielding debt globally,³ forcing investors to look beyond the government bond market for income.
When combined, these factors generate tremendous demand for higher-yielding securities, such as preferred securities, particularly as they feature stronger credit quality and lower default rates than high-yield bonds.
Better credit quality and lower default rates
Preferred yields are similar to those from high-yield issues;⁴ however, the average credit quality of preferred securities is BBB- or investment grade. High-yield bonds may indeed offer slightly higher yields, but at the cost of a lower credit rating (their average credit rating is B+, which is below investment grade).⁵ Furthermore, default rates are low for preferred securities, historically standing at only 0.33%, which makes sense given the average investment-grade rating. In contrast, global high-yield bonds have had a 30-year default rate of 4.06%.⁶ We believe the credit quality and default rate of preferred securities shouldn’t be adversely affected under the current environment.
What also distinguishes preferred securities from other areas of the fixed-income market, particularly high-yield bonds, is that they’re less sensitive to changes in interest rates. Many of them come with a fixed-to-floating-rate coupon structure where the coupon is fixed for the first 5 or 10 years of the life of the security, after which it floats. Even in a rising rate environment, investors are offered some coupon protection. This further adds to their core appeal—attractive yields with reduced credit risk—and explains why we believe they may be one of the more valuable portfolio tools.
In terms of sector preference, investors should be looking for companies with strong fundamentals, stable balance sheets, and attractive yields, particularly those in the U.S. utilities, energy, and financials sectors.
Sectoral focus—financials, utilities, and energy
In the utilities space, we believe that convertible preferred securities show attractive opportunities right now. Issuer fundamentals are solid, with virtually all U.S. utilities reiterating the earnings growth guidance that was given before the lockdowns. The positive catalysts stemming from their investments in renewables also look set to become even more optimistic under a Biden presidency. Although the sector has acted as a defensive hedge in 2020’s volatile markets, utility stocks are also at 20-year lows relative to S&P 500 Index valuations, thereby boosting future return potential.⁷
As for energy, we see investment opportunities in midstream companies with diversified business models (e.g., natural gas pipelines and gasoline storage). Given that natural gas is principally used for heating and electricity generation, we expect robust cash flows to continue.
U.S. financial companies have boosted their capital reserves since the 2008 global financial crisis. Balance sheets are in the best shape in decades,⁸ a key factor supporting their resilience amid a challenging economic environment. Also, apart from one large U.S. bank, all the major institutions have maintained their common dividends. We believe the market is discounting these fundamentals.
While there’s geographic concentration risk to the United States, we think the risk/return profile of preferred securities remains attractive. This stands in contrast to European financial institutions, which may also be forced by the regulators to halt dividend payouts.
A strong play in a low-yield world
As yields on traditional fixed-income securities, such as developed-market government bonds, continue to trend lower, preferred securities continue to offer compelling yields. What’s more, they have lower volatility, defaults, correlations, and interest-rate sensitivity. With the search-for-yield theme likely to continue in 2021, we believe preferred securities may provide the balance between yields and quality that investors clearly seek.
1 Manulife Investment Management, Bloomberg, as of November 30, 2020. Returns are in U.S. dollars. Preferred securities are represented by the Intercontinental Exchange (ICE) Bank of America (BofA) U.S. All Capital Securities Index. U.S. high yield is represented by the ICE BofA U.S. High Yield Index. Past performance does not guarantee future results. 2 OCED historical population data and projections, 2019. 3 Bloomberg Barclays Global Negative Yielding Debt Index, as of November 30, 2020. 4 Bloomberg, ICE BofA indexes, Manulife Investment Management, as of November 30, 2020. U.S. high-yield bonds, with yield to maturity 5.31%, are represented by ICE BofA High Yield Index. Preferred securities, with yield to maturity 4.37%, are represented by the ICE BofA U.S. All Capital Securities Index. Yield to maturity refers to the rate of return anticipated on a bond if it is held until the maturity date. It is not an accurate reflection of the actual return that an investor will receive in all cases. 5 Average credit ratings refer to Standard & Poor’s ratings, as of November 30, 2020. 6 Global high-yield bonds default rate is sourced from Moody’s Investor Services, as of December 31, 2019. The preferred securities default rate from 1990 to 2017 was calculated by Wells Fargo. Beginning in 2018, Manulife Investment Management used the ICE BofA U.S. All Capital Securities Index to calculate the annual default rate since Wells Fargo stopped providing related information after 2017. Past performance does not guarantee future results. 7 BofA Research, June 1, 2020. 8 Federal Deposit Insurance Corporation, November 2020.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other preexisting political, social, and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment
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