Mention the term ‘preferred securities’ and you are most likely to draw a blank response from European investors and consultants.
Across the Atlantic the preferred securities market is worth about $240bn (e196bn). From a standing start in 1993, that represents phenomenal growth but large international consultancies and asset managers gave negligible feedback when asked if they knew much about them or even recommended preferred securities to clients. Some asked if they were convertibles; others thought they were preference shares.
There is some irony to this ignorance given that 20% of preferred securities are issued by household European names, such as Spain’s Banco Santander. At the same time, the $240bn market is all in the US and while its European sibling is growing, important regulatory differences give the US an advantage.
Preferred securities in essence are subordinated debt. At the point when a company goes into liquidation, holders of senior debt paper and banks with short-term loaning facilities are higher up the pecking order than holders of subordinated debt. This is the key risk and is reflected in both a lower credit rating for preferred securities than senior debt but also a higher coupon. Typically the rating will be one or two notches lower than for senior debt while the coupon can be 175 bps higher in the retail market, which accounts for about 55% of the total. In the institutional market, the coupon is considerably lower than for retail – perhaps 40 bps higher than senior debt - but the terms are better.
The crucial better term regards the embedded call option found in most preferreds. This gives the issuer the right to call in the loan after a defined period. In the retail market the period is usually five years; for institutions, it is 10 years.
Kevin Conery, a preferred strategist at Merrill Lynch in New York, notes that investors expect the loans to be called in. While it is an additional uncertainty for long-term investors knowing how to factor call risk into their investments’ future, the US market has developed a step-up in pricing which introduces some sureness. The step-up means investors are likely to get an extra 100 basis points if a loan is not called in, which clearly incentivises companies to cease the debt but at the same time emphasises to lenders that they should not really expect the ultimate contractual maturity to be reached.
Contractual maturity is the possible difference between the US and European markets. According to Conery, regulations of the Bank for International Settlements require preferred securities to be perpetual to be included on as part of an issuer’s Tier One capital. US regulations, however, permit banks there to put fixed maturities. Conery reckons the perpetual nature of European issuance presents a real problem for potential European investors.
In the recent years of falling interest rates, a very high number of preferreds have been called in. Returns for the retail preferred securities in the second quarter of 2004 were miserable according to the Merrill Lynch Preferred Master Index although Conery noted that the retail market tends to outperform long-dated corporate and government bonds when rates rise, and that is now happening.
Nick Lyster, head of European marketing for Principal Financial Securities, says its philosophy is that it is better to buy into the subordinated debt of a financially strong company than the senior debt of an ailing or financially uncertain borrower. Through its subsidiary, Spectrum Asset Management, Principal has a preferred securities fund open to European investors with both dollar- and euro-denominated classes. In its first year it has taken in about $150m. Spectrum also runs a sub-advisory mandate for a private bank in Austria.
“Preferred securities are a tool with which investors can enhance yield and add some diversification,” says Lyster. “US pension fund clients typically allocate 10-15% to preferred securities within a fixed-income mandate.”
One final characteristic worth noting is that with preferreds, issuers have the right to withhold interest payments for up to five years. This facility, useful to a corporate treasurer seeking to restructure, might frighten off European investors. But, according to Lyster, no company has withheld payments that has not subsequently gone into liquidation. The facility tends not to be used and before it does, an issuer must first withhold dividend payments from common shareholders. So this is an extreme measure.