Preferreds Look Attractive, but Mind the Financials

Preferred securities prices were hit hard during the rate hiking cycle, leading to valuations not seen since the Global Financial Crisis and creating an attractive entry point for income-oriented investors. Some caution is warranted, however, as turmoil in financials and banks, industries that dominate preferred issuance, continues to linger.

Attractive Valuation and Yield Offer Entry to Preferreds

Given their long-dated maturities, and even perpetual nature, preferreds are highly sensitive to changing interest rates and bond yields. With the historic pace of the rate hiking cycle between 2022 and 2023, preferred prices plunged as the Federal Funds Rate rose from near zero to over five percent. Today, preferreds are trading at discounts to par value not seen since the Global Financial Crisis, representing attractive total return opportunities.

Historical Price to Par of the Preferreds Market | Jan. 2000 – Mar. 2024

Source: ICE Data Indices. Preferreds Market represented by the ICE BofA Fixed Rate Preferred Securities Index (P0P1). As of March 31, 2024.

The average price of the ICE BofA Fixed Rate Preferred Securities Index is now trading at a price-to-par ratio of roughly 0.92, indicating an 8% discount to par and an even greater discount to the 1.07 ratio seen in July 2021, just prior to the start of the rate hiking cycle. Outside of the 2008-2009 financial crisis and very briefly during the 2020 COVID crash, preferreds have rarely traded at the discount level seen today, creating a potential capital appreciation opportunity for investors.

Low prices have created an attractive opportunity from a yield perspective as well. Since yield moves inversely to price, the decline in prices has sent yields on preferreds soaring. The average yield-to-worst of the ICE BofA Fixed Rate Preferred Securities Index is now at about 6%. This is up sharply compared to the 3% average yield-to-worst seen at the beginning of 2022, giving investors the chance to lock in high yields on top of the capital appreciation opportunity.

Preferreds Have Historically Been Strong Performers Following Rate Hikes

Valuation and yield are one part of the story, but how can investors expect preferreds to perform given our position in current the rate cycle? Looking back at the performance of preferreds during the last four rate hiking cycles, after interest rates peak, returns in the preferreds market have been strong for the next two years. On average preferreds have returned over 15% in the two years following the final rate hike of the cycle. This average return increases to over 20% if you exclude the 2005-2008 rate cycle which was impacted by the Global Financial Crisis. While past performance is not a predictor of future outcomes, this data provides a favorable historical foundation.

Looking at the current cycle, this trend of strong performance following the final rate hike appears to be playing out similarly to past cycles. Since the last rate increase, in July 2023, the preferreds market is up about 10%. While it is still early, this recent performance could be a sign of more positive returns in the months ahead, particularly if rate cuts do begin this year and the U.S. economy remains resilient.

Performance of Preferreds During Interest Rate Cycles | As of March 2024

Source: ICE Data Indices. Preferreds Market represented by the ICE BofA Fixed Rate Preferred Securities Index (P0P1). As of March 31, 2024.

The Concentration Risk That Few Are Talking About

Concerns are abundant around the concentration risk of the “Magnificent 7” mega-cap stocks, which command nearly 30% of the S&P 500 and significantly influence the U.S. equity market. This concern is well-founded, but there exists another, and arguably more severe, concentration risk that has flown under the radar: the high financials and bank exposure within the preferred securities market.

Following the financial crisis in 2008, banks and other financial institutions began issuing a significant amount of preferred securities to meet the higher capital levels required by regulators. This proliferation of preferreds issuance by financial companies resulted in the sector's concentration, which now makes up over 80% of the U.S. preferreds market. Drilling down even further, the banking industry is specifically responsible for about half of this financial concentration, with the remainder being financial services and insurance companies¹.

This issue, though not receiving the same level of attention as the Mag 7, poses a risk that demands scrutiny, particularly as the recent turmoil of New York Community Bank (NYCM) reminds us that many banks are still navigating a challenging environment with high interest rates and impacted commercial real estate loan portfolios that could take years to playout. With banks making up roughly 40% of the preferreds market, any loss of confidence in the sector could severely impact the portfolios of investors. Just like many are looking to manage their Mag 7 equity exposure, we believe that the same risk management is warranted in the preferreds market as well.

Access to Preferreds Without the Financials

Those looking to take advantage of the valuation and yield opportunities present in the preferreds market while also avoiding bank exposure should consider the VanEck Preferred Securities ex Financials ETF (PFXF). PFXF offers investors access to the U.S.-listed preferred securities market that excludes securities issued by financials, which many might find particularly attractive given the current banking concerns.

Beyond the obvious benefits of excluding financials in the current market, ex-financial preferreds generally also offer a number of other benefits over the broad preferreds market that investors might find attractive. Historically, these include higher yield, greater sector diversification and strong relative performance compared to the broad preferreds universe.

The VanEck Preferred Securities ex Financials ETF (PFXF) seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the ICE Exchange-Listed Fixed & Adjustable Rate Non-Financial Preferred Securities Index (PFAN), which is intended to track the overall performance of U.S. exchange-listed hybrid debt, preferred stock and convertible preferred stock issued by non-financial corporations.

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