Hybrids: Best of both worlds
• Preferred securities are generally subordinated to senior debt and can defer payments without placing issuer into default.
• They are senior to common equity if there is a corporate liquidation.
• Yields on preferred securities are three to four times higher than senior bonds.
• Perpetual preferred securities whose interest rate is reset at a fixed point in the future are useful when monetary policy is expected to tighten.
• For investors complaining about the lack of yield in fixed income, there is a partial solution.
Preferred securities – also known as hybrids because they combine aspects of bonds with aspects of equity – offer high coupons and high yields compared with most purebred bonds. Triple-B preferred securities showed a yield of 5.4% at the end of August, not much lower than the 6.1% for B+ high-yield bonds, according to indices from Bank of America-Merrill Lynch.
To look at the yield numbers in another way, following a sharp rise in issuance in recent years, non-financial hybrids alone account for about 5% of the non-financial part Barclay Euro Investment-Grade index, but an even more substantial share – about 20% – of the non-financial yield, says Julian Marks, portfolio manager of the Corporate Hybrid Bond Fund at Neuberger Berman. The upshot: “Investors are having to wake up to this asset class.”
For the investment-grade preferreds that, according to preferred security specialist Spectrum Asset Management, make up about half of the market, the yield is the highest available in this segment of the bond market.
“I wouldn’t say valuations are cheap, but if you’re looking at the fixed-income market as a whole, preferreds can offer some of the best relative value,” says Brian Cordes, preferred securities portfolio specialist at Cohen & Steers, the investment manager, in New York. In the case of investment-grade, “you don’t find anywhere near the 5.4% you can get for preferreds”, Cordes says. He argues that for the risk involved, preferreds look good when compared with high yield. As a result, “that’s where we’ve seen a lot of investors allocate to preferred from. They haven’t eliminated their high-yield positions altogether, but they’ve reduced them and moved some of this into preferred.”
Moreover, regardless of whether the preferred security is investment-grade or speculative-grade, the strong creditworthiness of the overall enterprise is still reassuring. Phil Jacoby, CIO at Spectrum in Stamford, Connecticut, makes a similar point. “You’re going down the capital structure within issuing entities that are large and investment-grade at the senior debt level,” he says. “This makes it different from high-yield, where you are purchasing the senior debt of an enterprise which is below investment-grade and typically quite small in capitalisation and quite concentrated in the products and services it offers” – a concentration that makes it more sensitive to changes in its environment.
Yields are typically three to four times those of senior bonds issued by the same company. But it is a market that is hard to understand – not only because of the complex nature of the instruments, but also because of the various different types.
However, this complexity generates what Cordes describes as inefficiencies that can be exploited. This creates an incentive to understand them.
To start with what preferred securities have in common, they are in general subordinated to senior debt. Most can also defer or skip payments without placing the issuer into default. Although they are below senior debt, they are senior – or to put it another way, ‘preferred’ – to common equity in the event of a corporate liquidation.
Moreover, issuers typically cannot pay common equity shareholders without paying the coupons on preferred securities first.
Within these parameters, there are many subsets. One is the contingent convertible (or coco), which lies at the riskier end of the preferred securities market. If all goes well, contingent convertibles act like normal bonds, paying a coupon. However, if a certain pre-defined event happens – usually a fall in the bank’s capital ratio below the minimum level demanded by regulators – disaster strikes.
Some see their principles written down permanently, others are written down temporarily but can be resurrected if the capital ratio rises again, and others are converted into equity. These cocos are also known as Additional Tier-1s (AT1s) because they are converted into shares or written off should the bank’s common equity tier 1 ratio fall below a certain level.
AT1 issuance rose from zero in 2011 to $39bn (€33bn) in both 2014 and 2015, according to data provider Dealogic, although it has since fallen as banks have met their issuance needs.
Investors must also draw a distinction between preferred securities that have fixed rates and those that are floating. Among those that are floating, some have a ‘step-up’ formula whereby the spread rises after a certain number of years.
It is essential for investors to understand the varied nature of the preferred market because different types of preferreds will react differently to any given trend.
Cordes gives an example relevant to the present, when central banks are expected to begin, or in some cases continue, tightening monetary policy. “When rates are going higher you don’t necessarily want to own preferreds that are fixed rate and perpetual. But for preferreds that will be reset, the reset can be used as a way of managing duration risk.”
He refers back to 2013, when the yield on US 10-year Treasuries doubled from about 1.5% to 3% in six months or so. Fixed-rate perpetuals – which are bought mainly by retail investors – lost about 4.5% of their value. Perpetuals with resets rose by about the same amount. This was not just because of the reset property, but also because such bonds are issued by banks and insurers, whose profits, and hence creditworthiness, typically benefit from a rising rate environment through higher net interest margins and higher returns on their investment portfolios.
But even those investors who see the appeal of preferreds are acutely aware of the risks attached. The preferred market as a whole showed a negative total return of 6.6% in 2007, followed by a 28% plunge in 2008, according to Cohen & Steers – a cumulative loss much higher than that for high-yield bonds. This partly reflected the fact that the banking and insurance sectors, which account for so many of the preferreds, were at the centre of the crisis. Cohen & Steers has yet to suffer payment deferrals on the preferreds it has invested in since the global financial crisis, but in 2008 even it was caught out by the collapse of Lehman, a preferred issuer. The 2007 and 2008 slide also reflected a large fall in the value of junior debt.
In defence of preferreds, they bounced back by 33.2% in 2009. However, high-yield bonds rose by much more even than this. Moreover, even though preferreds have a good recent record when it comes to maintaining coupon payments, the AT1 sub-sector is being treated with caution by many investors, because of the potentially catastrophic properties of these securities.
Alexandra Van Gyseghem, head of investment-grade credit at Amundi, points out that the risk they pose is no mere theoretical possibility. In June the value of the AT1 bonds of Spain’s Banco Popular was wiped out after fellow Spanish bank, Santander, stepped in to rescue it.
Van Gyseghem’s solution is to invest only in safer banks, including “national champions”. She also
notes that when it came to Banco Popular, the exception proved the rule: “This event confirmed the strength of the asset class as there was almost no contagion to other large issuers.”