This week's chart above indicates how aggressively bank and finance companies have been at issuing preferred stock over the last few years. These securities are being issued to meet U.S. capital and Basel III regulatory requirements, frameworks which govern bank capital adequacy, stress testing and liquidity. From a trading and total-return perspective, preferred stocks act similar to high yield bonds and often come with high yield ratings.
While bank preferreds have some duration sensitivity and performance is periodically impacted by new issuance, I view their longer term risk/reward as attractive. Underlying this view is a belief that bank fundamentals are sound, driven by lower leverage levels and enhanced liquidity positions. Moreover, asset quality (non-performing loans and charge-offs) continues to improve, underpinned by strengthening residential and commercial real estate values and lack of mega leverage buy-out deals. Banks still face headwinds in the form of low interest rates (which pressure net interest margins) and ongoing litigation. However, these concerns are more for the equity market and should not obscure the bigger picture of stabilized credit quality.
Given improved bank credit quality, bank preferred stock can be a good alternative to corporate bonds at this point in the business cycle. This is due to the event risk and shareholder-friendly posture of many management teams. Within the corporate sector, the upgrade to downgrade ratio has been declining, leverage levels have been creeping up, free cash flow is being utilized for share repurchases and dividends, and debt financed merger and acquisitions (M&A) are being used to augment sluggish growth. Furthermore, since banks will benefit more than industrial and utility companies in a rising interest rate environment and steeper yield curve, they offer a hedge against this outcome. Banks have their own fundamental challenges, but they are not subject to the same late-cycle behavior as the corporate sector. Thus, I am comfortable moving down the capital structure of solid investment grade bank and finance companies into their higher yielding preferred securities.
Key Takeaway: If one adheres to the adage that the cause of the next credit market crisis will not be the same as the last, banks should fare well on a relative basis when the cycle turns. Despite their current volatility, their beta to the market should dissipate as balance sheets strengthen, liability structure becomes more stable, and the extensive regulatory oversight they are subject to creates a more utility-like business model. Lower levels of profitability notwithstanding, these factors make for a more bondholder- and rating-friendly sector.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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