A vote to consider preferred securities

Bottom line up top

Positive earnings growth still requires concentration. At the end of last week, 75% of the S&P 500 Index companies reporting third quarter results so far have beaten consensus estimates. That’s below the S&P 500’s 5-year average of 77%, but in line with its 10-year average of 75%, according to FactSet. But while the U.S. equity market rally has broadened beyond mega cap technology names to encompass a more diverse range of sectors and companies, blended earnings growth (a combination of reported earnings and estimates for those yet to report) for the overall index remains highly concentrated: Removing just the four largest contributing companies would reduce the S&P 500’s Q3 blended earnings growth rate from +3.4% to -0.1%. Estimates for all 11 index sectors improved modestly over the past week, however, a trend investors hope will continue. Between now and election day on 5 November, 213 companies, representing $25.7 trillion in market capitalization, are due to report.

The elephant (and the donkey) in the room. With the U.S. presidential election just eight days away, many investors continue to second-guess whether their portfolios are well-positioned for whatever lies ahead. We think it is critical to remain focused on long-term investment goals and attentive to the broader economic backdrop and company fundamentals, as election-driven volatility has historically been short-lived— even if the results of the election were not immediately known, as in 2000. With that in mind, corporate earnings, inflation and the direction of interest rates should continue to be the structural drivers of financial markets. This was evident in the recent backup in U.S. Treasury yields after they bottomed in mid-September following the U.S. Federal Reserve’s 50 basis points (bps) rate cut. Since then, the uptick in yields, paired with underlying fundamentals, may have created another attractive entry point for one of our favored fixed income sectors.

Portfolio considerations

Preferred securities, an investment grade asset class, is among the top performing fixed income sectors year-to-date, with a total return of +11.1% through 24 October (as measured by the ICE BofA All Capital Securities Index). This impressive gain has been driven by compelling yields, favorable supply/demand dynamics and strong bank earnings.

Among the different types of preferreds, we favor $1000 par securities, which are yielding 5.95% with a spread of 177 bps over U.S. Treasuries (Figure 2). Both $1000 par and contingent capital securities (CoCos) offer attractive levels of income relative to their duration risk.

Negative net supply for preferreds, specifically in the $25 par securities segment of the market, has resulted in a notable compression of option-adjusted spread (OAS) throughout the year. All else being equal, spread tightening drives price appreciation. In fact, $25 par securities now have a negative OAS. $1000 par securities haven’t experienced the same level of spread compression, which creates a meaningful relative value opportunity over $25 par preferreds.

Banks, the largest issuer of preferred securities, have generally beaten consensus earnings estimates this reporting season. Earlier this year, annual stress test results demonstrated the continued strength of bank balance sheets, with robust capital ratios. And a recent Fed proposal would require banks to hold even more capital. Lastly, European banks, the largest issuer of CoCos, remain well-capitalized and can provide geographic diversification within preferred strategies.

Not all preferred strategies are created equal. Passively managed strategies allocate primarily to $25 par securities. In contrast, actively managed strategies often invest across the preferreds market, seeking to take advantage of opportunities as they arise. Additionally, active management can increase tax efficiency by intentionally allocating to securities that generate qualified dividend income. These securities are taxed at a maximum individual rate of 23.8%, rather than the higher federal income tax rate of 40.8%. Given uncertainty around future tax policy ahead of the U.S. election, we expect demand for tax-efficient strategies will remain high. An allocation to preferreds may warrant consideration within both taxable and tax-exempt portfolios.