Recent Events Have Led to Uncommon Value Across the Preferred Securities MarketAdvice to the Advisor
Preferred stocks, as measured by the S&P Preferred Stock Index, were trading at their highest prices in over two years in mid-February until suffering a (36%) decline through March 19th amid the Coronavirus panic. Prices have recovered, but the index is still down substantially from the average price it has traded over the last 10 years. We believe the sell-off in these shares was the proverbial “throwing the baby out with the bathwater” type of decline and driven by a combination of liquidity needs, fear, and misunderstanding. We feel preferred shares offer uncommon value now for investors seeking income.
Why Preferred Securities Now?
Strong in February. The COVID-19 pandemic may be a violent economic shock and could result in a recession, or at least extreme weakness in the world economy in the short-term. Before the pandemic, most companies and consumers were in relatively good financial shape with low debt levels and high saving rates.
Short-term hit. The actions of government and central banks will determine the magnitude of the slowdown. The Fed is all in. Federal Reserve Bank of St. Louis President James Bullard has predicted unemployment may hit 30% in the second quarter, but, once the short-term hit passes, the U.S. economy then could see a “boom quarter where there’s a lot of production at that point,” thanks to “pent-up demand” resulting from the period of low activity. The government’s nearly $2 trillion rescue package should help prevent the sudden shock from turning into a long recession.
Banks are stronger now. The financial sector, the largest issuer of preferred securities, is strong due to reforms set in place after the global financial crisis in 2008. Banks are better capitalized today. Tier-1 capital ratios are double those of 2008, and banks are regularly tested to see if they have enough capital to survive a severe stress test. The results have shown that, after the stress test, the bank sector’s capital ratio would be comparable to the unstressed capital ratios before the financial crisis.
Profits may fall, but balance sheets are solid. Banks and insurance companies may see profitability fall due to lower interest rates and losses from investment or loan portfolios. Banks are sound and the government programs being discussed should offer some support to borrowers. Insurance companies should see little impact from virus claims or mortality risk. COVID-19 is a greater risk to the elderly who are less likely to have life insurance.
REIT preferreds. The impact on REITS, real estate investment trusts, depends on the type of property they lease. Travel-related properties and retail properties are being impacted by travel restrictions and retail stores being closed. The restrictions, while temporary, are having an impact on revenue and resulting in common share dividends being cut. However, the balance sheets for the most part are strong. The silver lining for REIT preferreds is that, if preferred dividends are cut, most REIT preferred stock dividends are cumulative.
Panic + illiquidity = price dislocation. The sudden risk-off panic selling coupled with the ease of trading a relatively illiquid security class via ETFs resulted in (30%) return in about 2 weeks. The four largest preferred ETFs saw redemptions of over $643 million, or 3% of their assets. In our opinion, this indiscriminate selling resulted in throwing the baby out with the bath water. Preferred issuers, in general, are financially strong, and, if the number of new COVID-19 cases starts to shrink, along with the strong central bank and government interventions to prop up demand, we may see a quick end to this global shock with financial markets quickly responding.
Potentially high dividend yield and total return. The current dividend yields on preferred securities in the index are now over 6%. Investor demand for income has not decreased. History has shown that, after equity market corrections of 10% or more, preferred securities have outperformed U.S. Treasuries and U.S. corporate bonds over both a 3-month and 6-month time frame.
At Sheaff Brock Institutional Group, we offer access to the preferred securities market both through an SMA and our Innovative Portfolios mutual fund family. For more information, go to preferred-plus.com, innovativeportfolios.com, and sheaffbrockinstitutional.com. Or reach out directly to Paul Massie, CFA, CAIA, Head of Intermediary Distribution for Sheaff Brock Institutional Group, at 317.705.5120 or via email at firstname.lastname@example.org.