Wednesday, July 19, 2023
Preferred securities have had a Jekyll and Hyde year so far in 2023. After starting off the year as one of the best performing asset classes, returns for the ICE BofA U.S. All Capital Securities Index since March, have lagged other plus sectors. Preferreds are issued primarily by financial institutions with the largest issuers being banks and insurance companies. REITs, utilities and other financial institutions also issue preferreds. Preferred securities count toward regulatory capital requirements, so banks issue preferreds to help them maintain their required capital ratio. Preferred securities are highly correlated with the health of the financial system, so the recent concerns about the solvency of some banks have concerned investors, resulting in underperformance.
However, the Federal Reserve (Fed) recently released the results of its annual stress test on large banks in the U.S. and all 23 banks tested passed easily. Specifically, all 23 banks exceeded their minimum capital levels after being put through the ‘severely adverse scenario’ that envisioned a deep global recession, generating $541 billion in aggregate bank losses. Key factors in the stress test included a 6.4% rise in unemployment (peaking at 10%), a 40% decline in commercial real estate (CRE) prices, and a 38% decline in house prices. These losses of over half a trillion dollars would decrease the banks’ aggregate common tier 1 (CET1) capital by 2.3%, resulting in a minimum CET1 ratio of 10.1%—still a healthy double-digit level, and more than twice the minimum regulatory capital ratio. This 2.3% CET1 drop is less than the 2.7% drop experienced in the 2022 stress test. All other stressed capital and leverage ratio targets were also comfortably exceeded.
The results of the tests are comforting after the banking concerns that arose earlier this year. Moreover, while not subject to these tests, U.S. bank regulators are considering a range of actions to further strengthen the financial system, including the potential for smaller banks to undergo annual testing as well. These test results demonstrate the robust creditworthiness of U.S. banks and further affirm our positive view on preferred securities. And while there may still be concerns around some of the smaller regional banks, the large banks are the largest issuers of preferreds, and given the recent results of the stress tests, are seemingly in good shape. Nonetheless, with yields and spreads still trading around the highest levels since the Global Financial Crisis, we think the risk/reward for preferreds is still attractive.
We still recommend the majority of fixed income exposure to be allocated to higher quality core bonds but for those income-oriented investors willing to take on some additional credit risk, preferred securities may be an attractive investment to consider. And while there are a number of options available for investment, our preferred expression within the sector is through active management due to the different markets with different characteristics as well as the ongoing potential for winners and losers in the banking sector.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks
References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.
Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.
Preferred stock dividends are paid at the discretion of the issuing company. Preferred stocks are subject to interest rate and credit risk. As interest rates rise, the price of the preferred falls (and vice versa). They may be subject to a call feature with changing interest rates or credit ratings.
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