The good and the bad of preferred securities
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.