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August 25, 2022

Preferred Market Update

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August 25, 2022

Preferred Market Update


Insight Article

Preferred Market Update

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August 25, 2022

 
 

The ICE BofA Fixed Rate Preferred Securities Index rallied over 6% in July as risk assets recovered from steep losses in June. The Fed hiked another 75 basis points (bps) and the yield curve flattened, with the 10-Year Treasury yield declining 36 bps to 2.65%. Preferred ETF fund flows turned positive for the first time this year, and $25 Par preferreds led the market higher, rising 6.4%, while 1000 par rose 4.1%.1 Positive returns resuscitated the primary market, which reopened after a two-month hiatus, while strong second quarter results from financial institutions supported the case for capital securities.

 
 

If June was about investors pricing in recession risk, July had markets adjusting this outlook for the current mix of economic data. July saw preliminary GDP for Q2 meet the technical definition of a recession – two consecutive quarters of negative real growth – yet August payrolls topped 500,000 with a 3.5% unemployment rate. While growth is slowing, particularly in areas such as manufacturing, continued jobs gains and resilient consumer balance sheets may imply a more benign outcome for corporate credit. With yields near multi-year highs, buyers began to reemerge, and preferred ETFs returned to inflows, up $105 million, to take the total to negative $3.7 billion for the year, according to Bloomberg data.

The primary market returned to life in July, but supply remains down over 70% versus this time last year.2 In Canada, two banks priced fixed to floating CAD-denominated issues with yields above 7% mid-month. In the U.S., we had the first $25 par issue since May as a money center bank priced a 1 billion deal at 6.5% fixed for life. Continuing the momentum, three European banks priced contingent convertible securities in USD with coupons from 7.75 to 8% the first week of August.

Banks reported second quarter results in the month and the broad themes were positive for credit investors. Earnings demonstrated continued loan growth, for the third quarter in a row, and increasing net interest income. Delinquencies and net charge offs remain well below historical averages. Investment banking was weak on a slowdown in M&A and equity underwriting, but fixed income trading performed well on macro volatility. Capital levels declined sequentially due to mark to market portfolio losses, and combined with June stress test results, some of the largest banks chose to suspend stock buybacks to build capital.

 
 
 
Returns and Metrics
 

Source: Bloomberg, as of July 31, 2022.

The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure section for index definitions

 

 
 
 
Preferred ETF Flows
 

All chart data from Bloomberg as of July 31, 2022. Past performance is no guarantee of future results.

 
 
 
Ratio of 1000 Par to BB High Yield OAS
 
 
 
 
Cumulative U.S. Preferred Issuance
 
 
 
 
Yield to Worst: 1000 Par and 25 Par
 
 
 
 
Ratio of 1000 Par to Senior Financial OAS
 

All chart data from Bloomberg as of July 31, 2022. Past performance is no guarantee of future results.

 
 

6% is a decent year in preferreds – July’s return bested the 5.86% annualized return of the ICE BofAML Fixed Rate Preferred Securities Index since inception in 1989 – but the rally still leaves the index down over 8% this year. While we expect markets to remain volatile, starting yields in preferreds are attractive to historical levels. In portfolios we remain focused on tax loss harvesting and relative value opportunities, but the combination of strong equity markets and a flattening yield curve has benefitted fixed for life securities disproportionately. We have shortened duration and increased the allocation to fixed to floating rate securities in $25 par portfolios, as the index now trades more than 150bps inside of $1000 par on an OAS-basis. In $1000 par, we are finding better values in floating rate securities than in some of the short call, high back-end fixed to floating rate preferreds.

1 Source: Bloomberg, as of July 31, 2022
2 Source: Bloomberg, as of July 31, 2022

The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure section for index definitions.

 
 

 

Risk Considerations

There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks.

Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Municipal securities are subject to early redemption risk and sensitive to tax, legislative and political changes. Taxability Risk: Changes in tax laws or adverse determinations by the Internal Revenue Service (“IRS”) may make the income from some municipal obligations taxable. By investing in investment company securities, the portfolio is subject to the underlying risks of that investment company’s portfolio securities. In addition to the Portfolio’s fees and expenses, the Portfolio generally would bear its share of the investment company’s fees and expenses. Preferred securities are subject to interest rate risk and generally decreases in value if interest rates rise and increase in value if interest rates fall. In addition to the risks associated with common stocks, investments in convertible securities are subject to the risks associated with fixed-income securities, namely credit, price and interest-rate risks. High yield securities (“junk bonds”) are lower rated securities that may have a higher degree of credit and liquidity risk.

 
kevin.lynyak
Managing Director
Fixed Income Managed Solutions
 
james.benadum
Vice President
Fixed Income Managed Solutions
 
 
 
 

DEFINITIONS

The indexes shown in this report are not meant to depict the performance of any specific investment, and the indexes shown do not include any expenses, fees or sales charges, which would lower performance. The indexes shown are unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

“Bloomberg®” and the Bloomberg Index/Indices used are service marks of Bloomberg Finance L.P. and its affiliates, and have been licensed for use for certain purposes by Morgan Stanley Investment Management (MSIM). Bloomberg is not affiliated with MSIM, does not approve, endorse, review, or recommend any product, and does not guarantee the timeliness, accurateness, or completeness of any data or information relating to any product.

The iBoxx Contingent Convertible Indices represent the developed and emerging market Contingent Convertible (CoCo) fixed income market for EUR, GBP and USD denominated bonds.

The Bloomberg U.S. Corporate 1-3 Year Index measures the investment grade, fixed-rate, taxable corporate bond market with 1-3 year maturities.

The CIPS/Markit UK Manufacturing Purchasing Managers’ Index (PMI) is a composite index based on five of the individual indexes with the following weights: New Orders - 0.3, Output - 0.25, Employment - 0.2, Suppliers’ Delivery Times - 0.15, Stock of Items Purchased - 0.1, with the Delivery Times Index inverted so that it moves in a comparable direction.

The Citigroup Economic Surprise Indices are objective and quantitative measures of economic news. They are defined as weighted historical standard deviations of data surprises (actual releases vs. Bloomberg survey median). A positive reading of the Economic Surprise Index suggests that economic releases have on balance been beating consensus.

The ICE BofAML Contingent Capital Index tracks the performance of investment grade and below investment grade contingent capital debt publicly issued in the major domestic and Eurobond markets.

The ICE BofAML Core Plus Fixed Rate Preferred Securities Index tracks the performance of fixed-rate US dollar-denominated preferred, U.S.- domiciled securities.

The ICE BofAML Eurodollar Banking Index is a subset of ICE BofAML Eurodollar Index including all securities of Bank Issuers and tracks the performance of US dollar denominated investment grade quasi-government, corporate, securitized and collateralized debt publicly issued in the eurobond markets.

The ICE BofAML Fixed Rate Preferred Securities Index tracks the performance of fixed rate, U.S. dollar denominated, investment-grade preferred securities in the U.S. domestic market.

The ICE BofAML U.S. All Capital Securities Index is a subset of the ICE BofA Merrill Lynch U.S. Corporate Index including all fixed-to-floating rate, perpetual callable and capital securities.

The ICE BofAML U.S. High Yield Master II Constrained Index is a market-value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment-in-kind securities. Its securities have maturities of one year or more and a credit rating lower than BBB-/Baa3, but are not in default.

The ICE BofAML U.S. Corporate Index (C0A0) tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market.

The ICE BofAML U.S. Corporate BB Index is a subset of the ICE BofAML US High Yield Master II Index tracking the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market. This subset includes all securities with a given investment grade rating BB.

The ICE BofAML U.S. Corporate B Index is a subset of the ICE BofAML US High Yield Master II Index tracking the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market. This subset includes all securities with a given investment grade rating B.

The ICE BofAML U.S. Corporate C Index is a subset of the ICE BofAML US High Yield Master II Index tracking the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market. This subset includes all securities with a given investment grade rating CCC or below.

The ICE BofAML U.S. High Yield Institutional Capital Securities Index (HIPS) tracks the performance of US dollar denominated investment grade hybrid capital corporate and preferred securities publicly issues in the US domestic market.

The ICE BofAML U.S. Investment Grade Institutional Capital Securities Index (CIPS) tracks the performance of US dollar denominated investment grade hybrid capital corporate and preferred securities publicly issued in the US domestic market.

KBW Bank index measures the performance of leading banks and institutions that are engaged in banking activities.

Current yield is a measure that looks at the current price of a bond instead of its face value and represents the return an investor would expect if he or she purchased the bond and held it for a year. Calculated by dividing the Annual Cash Inflows / Market Price.

Effective duration takes into account that expected cash flows will fluctuate as interest rates change.

Option Adjusted Spread is a measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst would use the Treasury securities yield for the risk-free rate. The spread is added to the fixed-income security price to make the risk-free bond price the same as the bond.

Yield-To-Maturity is the rate of return anticipated on a bond if it is held until the maturity date.

Yield-To-Worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting. The yield to worst is calculated by making worst-case scenario assumptions on the issue by calculating the returns that would be received if provisions, including prepayment, call or sinking fund, are used by the issuer.

IMPORTANT DISCLOSURES

One basis point = 0.01%

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