Banking Stress and Preferred Securities: Now What?
The preferred security market has been hit hard lately. With banks and other financial institutions being the most common issuers of preferreds, the recent banking sector turmoil has resulted in more volatility and lower prices.
Our guidance is unchanged, but with some caveats. We continue to suggest a neutral allocation to preferreds, meaning investors can consider them if an investment in preferred securities is in line with their risk tolerance and investing time horizon. Volatility is likely to remain elevated, however, and additional price declines are possible. While the entry point appears attractive for long-term investors, some caution is warranted over the short run.
Most importantly, and as we'll discuss below, security selection is important in the current environment. Preferred securities issued by the large, highly rated banks have generally held up better than preferreds issued by small and midsize banks, and we expect that trend to continue.
Preferred security prices remain near their cyclical lows. Closing at $85.7 on May 16th, the average price of the ICE BofA Fixed Rate Preferred Securities Index is still near its lowest level in more than 12 years. Volatility remains elevated, as the right side of the chart below suggests, with prices rising and falling sharply over the past year. Prices initially fell last year as bond yields surged. As hybrid investments with characteristics of both stocks and bonds, preferred securities' long maturities (or no maturities at all) make them very sensitive to interest rate changes. Prices plunged last year as the 10-year Treasury yield rose more than two percentage points.
The recent volatility, however, is due more to bank sector concerns sparked by the early March failures of Silicon Valley Bank and Signature Bank. With banks representing a large share of the market, preferred investors appear concerned that more bank failures could harm the market. Because many bank preferreds are considered a form of stock, there likely wouldn't be much recovery value left for preferred investors should the issuer fail.
Preferred prices remain near their recent lows
Source: Bloomberg, using weekly data as of 5/16/2023
Past performance is no guarantee of future results.
The banking turmoil has had an outsized impact on preferred securities, because banks tend to be the largest issuers of preferreds. Preferreds issued by financial institutions make up roughly 86% of the ICE BofA Fixed Rate Preferred Securities Index. The Financials sector includes a handful of industries, like banks and insurance companies, for example. As you can see in the chart at right below, banks make up almost 55% of the index, the largest share relative to other financial institutions industries.
Banks make up a large share of the preferred securities market
Source: Bloomberg, as of 5/12/2023
Sector and industry weights of the ICE BofA Fixed Rate Preferred Securities Index. Sector percentages do not add up to 100% due to a small allocation to cash. For illustrative purposes only.
Large U.S. banks have generally performed better than small and regional banks after the recent bank failures—that's been true in both the common stock and preferred stock markets. A key issue leading up to the recent failures was the amount of deposits held by banks relative to the value of their bond holdings. Banks generally invest the deposits into investments with higher yields. But given the rise in interest rates last year, the value of many of those bond investments fell, but the value of the deposits didn't. That's a risk if many bank customers should want to withdraw their deposits at the same time, because the value of the bank's investments might not be enough to cover those withdrawals.
Given that risk, small and midsize regional bank common stocks have underperformed the broad bank stock market index. The chart below compares the year-to-date total return of the broad S&P 500 Banks Industry Group Index to the KBW Regional Banking Index.
Regional banks have underperformed the broad bank index year-to-date
Source: Bloomberg, using daily data as of 5/16/2023
S&P 500 Banks Industry Gross Total Return Index (S5BANGTR Index) and KBW Regional Banking Total Return Index (KRXTR Index). Returns include reinvestment of dividends. The S&P 500 Banks Index comprises stocks that are classified in the Global Industry Classification Standard (GICS®) as asset management & custody banks, diversified banks, regional banks, other diversified financial services and thrifts & mortgage finance. The KBW Bank Index, developed by the investment bank Keefe, Bruyette, and Woods (KBW), includes stocks represent large U.S. national money center banks, regional banks, and thrift institutions. Past performance is no guarantee of future results.
To gauge the performance of the preferreds, we screened for securities using the following criteria:
- Moody's rating of Ba3 or above or Standard and Poor's rating of BB- or above1
- Par values of $25, $50, or $100
- Amount outstanding of $100 million or more
- Denominated in U.S. dollars
- Issued by banks and diversified financial institutions
The scatter chart below compares the total returns of the individual preferreds that fit the above criteria with the size of the issuing bank, according to the issuer's total assets. The results are in-line with the stock chart above, where regional banks are generally underperforming the broad bank stock index.
In this chart, the year-to-date total returns are on the Y axis, with the issuing banks' total assets on the X axis. The bubbles represent individual preferred securities, and the size of the bubble represents the size of each issue relative to others. For example, the largest bubbles represent preferred issues that have more than $2 billion outstanding, while the smaller bubbles represent issues as small as $100 million.
Preferreds issued by banks with the most assets have performed the best this year. For the securities included in the screen, every preferred security issued by a bank with $1 trillion or more in assets has posted a positive total return this year. When we look at the small and midsize banks, on the left side of the chart, the dispersion of total returns is much wider, and the sizes of the negative returns for some of the issuers have been sharp. Finally, the preferreds that have a relatively small amount outstanding have been some of the worst performers, as illustrated by the size of the bubbles.
Preferreds issued by large banks have generally performed the best this year
Source: Schwab Center for Financial Research with data from Bloomberg
There are a total of 108 preferred securities in the chart, representing the issues that made it through the screen mentioned above. Y axis represents the total return of each preferred security from 12/31/2022 through 5/16/2023 and the X axis represents the issuing banks total assets held on the balance sheet. Past performance is no guarantee of future results. For illustrative purposes only.
We believe this trend may continue, with preferreds issued by large banks holding their value more than those issued by small banks as banking concerns linger. The large, highly rated U.S. banks appear to be in better shape to withstand a potential outflow of deposits, and their more diversified business models can help them weather a potential economic slowdown.
What to do now
Most importantly, make sure that any investment in preferred securities matches your risk tolerance. They should generally be considered moderate- to aggressive-risk investments given their high interest rate risk and credit risk (the risk that an issuer will fail to make interest payments or pay back principal). For more conservative investors looking for income today, we prefer investment-grade rated corporate bonds. For those investors who are willing to take more risk to earn higher yields, highly rated preferreds appear more attractive than high-yield bonds. If the economy slows, as we expect, high-yield bond prices may fall sharply, but the prices of preferreds issued by the large, highly rated U.S. banks may hold their value better.
If you are considering preferreds, those issued by large, highly rated banks appear to be the most attractive now. While their prices have generally held up better than the preferreds issued by small and midsize banks, meaning their yields are likely lower, they should perform a bit more defensively should banking turmoil remain a risk in the near-term.
Investors who hold individual preferreds should always look at the characteristics of any preferred security they are considering, and not just search for those with the highest yields. If a given security—preferred or otherwise—offers a significantly higher yield than what appear to be similar securities, there's likely additional risk with that issue or issuer.
Finally, given the bifurcated nature of the market lately, an approach that uses active management, like a mutual fund or a separately managed account, might make sense. With an active strategy, a portfolio manager can make the decision about what to hold—or more importantly in today's environment, what not to hold.
1 Ba3 represents the Moody’s Investors Services rating scale, and BB- represents the Standard & Poor’s rating scale. Ba3/BB- ratings are considered speculative and imply substantial credit risk. The preferred security screen in this article included preferred issues with ratings of Ba3/BB- or above as many banks whose senior unsecured bonds are rated investment grade have preferred securities that are rated a few notches below. The Moody’s investment grade rating scale is Aaa, Aa, A, and Baa, and the sub-investment grade scale is Ba, B, Caa, Ca, and C. Each rating (aside from Aaa, Ca and C) has a numerical modifier of 1, 2, or 3. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates amid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category. Standard and Poor’s investment grade rating scale is AAA, AA, A, and BBB and the sub-investment grade scale is BB, B, CCC, CC, and C. Ratings from AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories.