Katch Invest

The good and the bad of preferred securities

The good and the bad of preferred securities

The-good-and-the-bad-of-preferred-securities
By Pascal Rohner – Katch Investment Group CIO

Preferred securities have emerged as an attractive alternative for fixed-income investors. They have offered relatively stable returns around 6% over the last 8 years. The yields of preferred securities are significantly above the yields of corporate investment-grade bonds. In fact, they have been much more comparable to those of high-yield bonds. At first glance, this makes them very appealing for investors because unlike high-yield bonds, preferred securities are generally issued by big, well-known financial institutions, and most have investment-grade ratings, meaning that at least two of the big rating agencies (Standard & Poor’s, Moody’s, and Fitch) give them a credit rating of BBB- or above. Also, default rates of preferred securities have been markedly lower than those of high-yield bonds because of the fact that after the global financial crisis of 2008, the banking and insurance industries strengthened their balance sheets, driven by regulatory changes such as the Dodd-Frank Act in the US and Basel III in Europe. Tougher regulations forced banks to hold more capital reserves and use less leverage, which has made their business models more robust with steadier profits and less risk. This is obviously good for the industry’s credit fundamentals.

However, there is a saying in finance that if it sounds too good to be true, it probably is. Preferred securities are very complex instruments, and it is very important to understand them well before investing.

Preferred securities, also known as “preferreds” or “hybrids,” are similar to but not exactly the same as the more traditional preferred or preference shares markets. Preferred shares were first issued in the 19th century by railway companies. Investors demanded “preference,” or priority, in the payments of dividends over holders of common shares. In the 1970s and 1980s, the preferred share market evolved to finance the construction cycle of US utilities. In the early 1990s, many US banks issued preferred shares to restore their capital after the savings and loan crisis.

More recently, preferred securities have been issued mainly by large banks and insurance companies for regulatory reasons. The global financial crisis, which hit its worst moment with the default of Lehman Brothers, wiped out billions of dollars and severely damaged the balance sheets of big banks. What is more, several big institutions in Europe and the US only survived because governments used taxpayers’ money to save them, a move known as a “bail-out.” It is logical that governments and regulators reacted to the crisis by implementing stricter capital rules. Their main goals have been to strengthen banks’ capital bases and to reduce risk capital. New regulations paved the way for a new generation of preferred securities that are deeply subordinated in the capital structure. If certain criteria are met, these securities might be included as part of the regulatory core capital, also known as “tier 1 capital,” which typically consists of common equity (“common stock”) and “additional tier 1 capital.”

The details and naming differ depending on the different jurisdictions, but they generally have similar features: First, they are deeply subordinated, which means that in the event of a default, investors only get their money back after all senior bond holders are paid. Certain preferred securities rank even below common equity in the balance sheet structure. For example, in Europe, banks are incentivized to issue contingent convertible bonds, also known as CoCo bonds, which are a sub-segment of preferred hybrid securities. These bonds are automatically converted into equity or, more often, written down as soon as a bank’s regulatory core capital base falls below a certain threshold. Second, coupon payments can be skipped at any time without creating a default. More importantly, these coupon payments are typically non-cumulative, which means that investors do not have the right to claim any of the unpaid coupons in the future. The only investor protection is that if a financial institution does not pay a coupon on its preferred securities, it cannot pay dividends on its common shares—and sometimes it cannot pay bonuses. However, political support for the latter is fading. Finally, additional tier 1 capital securities typically do not have a stated maturity date but are perpetual in nature, with call options for the issuers after a 5- or 10-year initial period.

The previous description is clearly far from complete, but it gives a good idea of the complexity of these securities. Banks have a lot of discretion in their design features, which makes them highly complex and opaque instruments. They are fraught with numerous risks that make them very difficult to analyze and to price. The European Securities and Markets Authority (ESMAE), amongst others, stated that these securities are not suitable for private investors. Indeed, the sale of these products to retail investors is prohibited in the UK. Even institutional investors seem to find it difficult to price these securities.

Nevertheless, the near-term outlook for the preferred securities asset class appears positive. There is little stress in the financial sectors, and the contagion risk is low. Even the wipeout of CoCo bond holders of Banco Popular in 2017 did not cause major stress, as there are almost no cross holdings of preferred securities between banks. The main holders are hedge funds and retail investors (via mutual funds and ETFs). Investors still get a coupon of above 5% when holding preferred securities. However, investors should not ignore the numerous risks. Diversification is key, and no more than 10% a portfolio should consist of preferred securities. The future is not predictable, and it is important to remember why deeply subordinated preferred securities were created. Big banks should be able to survive in tough times without needing taxpayers’ money. In the next crisis, investors—especially the ones that own deeply subordinated preferred securities—are expected to absorb the losses.

By accessing this website content, you agree to be bound by the conditions.

It is important that you read the following page before proceeding, as it explains certain legal and regulatory restrictions applicable to the distribution of this information. By accessing any content of this website, you agree to be bound by the conditions. If you do not agree to the conditions, please exit the website. Neither Katch Investment Group; Katch Fund Solutions – Global Lending Opportunities Fund, Katch Fund Solutions – Real Estate Lending Fund, or Katch Fund Solutions – Factoring Fund (the “Funds”) will be responsible for any misrepresentations you may make in gaining unauthorized access. It is your responsibility to inform yourself of and to observe all applicable laws and regulations of the relevant jurisdiction. This website content is intended to be for information purposes only and it is not intended as promotional material in any respect. The information contained in this website (including marketing presentations, factsheets, and articles) does not constitute a distribution, an offer to sell or the solicitation of an offer to buy any securities in any jurisdiction in which such offer or invitation is not authorized and/or would be contrary to local law or regulation. This website is not intended for any “U.S. Person” as defined in the Prospectus. For more information write us at info@katchinvest.com. The information contained on this site, and on downloadable materials is believed to be accurate at the date of publication, but no warranty of accuracy is given, and the information is subject to change without notice. Any opinions or estimates included herein constitute a judgment as of this date and are subject to change without notice. If you are in any doubt about the information contained herein please consult your stockbroker, solicitor, accountant, bank manager or other professional adviser. All content and information are being made available free of charge. By proceeding you agree to the exclusion of any liability in respect of any errors or omissions contained in it. No liability is accepted by any person within Katch Investment Group or the Funds for any losses or damage arising from the use or reliance on the information contained herein including, without limitation, any loss of profit, or any other damage direct or consequential.

Investment in emerging market involves risk factors and special considerations which may not be typically associated with investing in more developed markets. Political or economic change and instability may be more likely to occur and have a greater effect on the economies and markets of emerging countries. Adverse government policies, taxation, restrictions on foreign investment and on currency convertibility and repatriation, currency fluctuations and other developments in the laws and regulations of emerging countries in which investment may be made, including expropriation, nationalization or other confiscation could result in loss to the Funds. The risk factors referred to above are not an exhaustive list and reference should be made to the relevant Prospectus. The value of investments and the income from them may go down as well as up and you may not get back your original investment. The Funds are intended for sophisticated investors who can accept the risks associated with such an investment including a substantial or complete loss of their investment. Past performance is not necessarily a guide to future performance. A person within Katch Investment Group and/or Katch Fund Solutions, its affiliates, their directors and the investment funds/accounts it manages may or may not have a position in or with respect to any securities mentioned herein.This website is solely reserved to investors that are located in France and defined as Professional Investors as per the AIFM Directive, or investors that are located in Switzerland and defined as Well-Informed Investors as per the Luxembourg act of 23 July 2016 on reserved alternative funds.

Special note for investors in Switzerland: Home country of the Fund: Luxembourg. The representative in Switzerland is 1741 Fund Solutions AG, Burggraben 16, CH-9000 St. Gallen. The Swiss Paying Agent in Switzerland is Tellco LTD, Bahnhofstrasse 4, 6430 Schwyz, Switzerland. The offering memorandum and other key investor information document or fund contract as well as the annual reports may be obtained free of charge from the representative. In respect of the units distributed in and from Switzerland, the place of performance and jurisdiction is the registered office of the Representative.

If you have read, understood, and accepted above conditions, you can enter.