Preferred securities: The overlooked fixed income alternative

29/04/2020
preferred-securities

Summary

Preferred securities, or preferreds, play a unique role in investment portfolios while occupying a special place in corporate capital structures. These hybrids feature characteristics of both stocks and bonds, making them an attractive complement to “pure” equity and debt securities. Now may be a good time to consider this often-overlooked asset class and explore whether an allocation might be appropriate in the context of an investor’s risk and return objectives.

Key takeaways

  • Preferreds are income-producing securities with bond and equity characteristics that aim to provide investors with high income and good relative value.
  • The wide variety of preferred security structures enables investors to diversify a fixed income portfolio and potentially manage interest rate risk.
  • Preferreds have historically offered attractive yields of approximately 6% and an investment grade average quality of BBB.

Preferred securities are a relative niche investment class, but their growing popularity ($1 trillion in issuance vs. $1.3 trillion in high yield1) reflects their appeal to investors seeking a level of potential risk and reward between equity and debt securities while providing issuers with an additional source of capital.

Like stocks preferred securities issued to retail investors trade on major exchanges. They have the potential to rise or fall in value but generally exhibit less volatility than the issuer’s common shares. And preferred shareholders have a prior claim over common stockholders to the corporation’s assets in the event of a liquidation.

Like bonds preferreds provide investors with current income through recurring payments, which may be fixed or floating. Preferred shareholders stand in line ahead of common shareholders for dividend payouts, whose yield is generally higher than the dividend yield on the issuer's common stock. 

In this white paper, we describe preferred securities and present a comparison of preferred to other income-producing securities on the basis of yield and quality, their correlations to other major asset classes, the characteristics that make them exhibit less interest rate risk. We also provide an overview of the issuer landscape by industry group and investor segment. Finally, we define key attributes that may render one preferred issue more suitable for an investment portfolio than another.

Preferred-Securities-EN-Fig01

 

What are preferred securities?

Preferreds, sometimes referred to as hybrids, are income-producing securities with bond and equity characteristics that aim to provide investors with high income and good relative value. While companies are able to mix various debt and equity features to create securities that suit their needs, common features are often: long dated or perpetual maturities with call dates after 5 or 10 years, subordinated in the capital structure, and able to defer payments without triggering an event of default. The wide variety of security structures available in the market enables investors to diversify their fixed income portfolio and potentially manage interest rate risk.

Preferred-Securities-EN-Table01

 

Who issues them and why?

  • Preferred securities represent an important source of non-common equity capital for regulated entities
  • Post-Global Financial Crisis regulations have sought to reduce systematic risk by increasing loss absorbing capacity at banks. While the first line of defense is higher common equity requirements, regulators also require a layer of perpetual noncumulative capital, known as Additional Tier 1 Capital or AT 1
  • Banks comprise a substantial portion of the market (57%) due to these regulations

Preferred-Securities-EN-Table02

 

Features of Preferred Securities

  • Attractive Yields: Preferred securities have historically had higher yields when compared to other traditional fixed income asset classes.
  • High Quality Income: Typically investment grade rated, preferred securities generate a high level of steady income, and the combination of market appreciation and income can generate yields above 5%.
  • Lower Interest Rate Sensitivity:  Designed to have less interest rate sensitivity than most other fixed income options, preferred securities available in floating rate and fixed-to-floating rate instruments. Abundant fixed-to-floating rate preferred structures are available to help investors manage interest-rate risk.
  • Increased Diversification:  Limited correlation with other asset classes increases portfolio diversification benefits. The variety of security structures within the preferred market allow for investors to customize their holdings to create a portfolio with the risk/reward features that suit their diversification requirements.
  • Large & Liquid Asset Class:  Preferred securities comprise a $1 trillion market.  Like US fixed-income markets in general, they exhibit significant and repeatable valuation inefficiencies which can be exploited to the benefit of investors through a dedicated bottom-up security selection process.

Preferred-Securities-EN-Fig02

 

A brief history

Preferred securities were first introduced in the 19th century to help finance the completion of the railroads and canals. New investors in those projects demanded a priority dividend payment over the existing common shareholders given the significant additional capital financing required to complete the projects and the improbable distribution of common dividends over the near term. The term “preferred” refers to the holders’ payment priority over common stock. Investors ceded their voting rights and the potential for future capital appreciation normally associated with equity in exchange for a preferred income stream and a priority claim on assets relative to existing shareholders in the event of a company’s liquidation.

All payments to preferred holders must be made before any payments to common equity holders. However, payments to the preferred class may be deferred or omitted – although this is rare and occurs only if a company is in financial distress. Like equities, preferreds have very long, often perpetual, terms. Deep subordination, the ability to defer or forego payments and long duration are features that generally drive security credit ratings 3 to 5 notches lower than the issuer’s senior debt.

Preferred-Securities-EN-Fig03

Collectively, the market for preferred securities is roughly $1 trillion, a four-fold increase since 2005. The preferred securities market is roughly equal to the size of the high yield market ($1.3 trillion), both of which are a fraction of the size of the US equity market (more than $30 trillion).2

Preferred-Securities-EN-Fig04

In the US, the preferred market became synonymous with the $25 exchange-listed market, which is dominated by retail investors given the small par size. However, the $25 market is only part of the market available to issuers. A $1000 over-the-counter market also exists, where institutions trade large lots, similar to the bond market.

 

Frequently overlooked

Despite market growth, an allocation to preferred securities is often missing from investors’ portfolios. The hybrid nature of a preferred may make it difficult to fit this investment class neatly in either the debt or equity universe.

For investors, preferred securities have acted more like bonds. Preferreds have a fixed par amount, make scheduled payments at either a fixed or floating rate, and often carry a rating from a credit rating agency.

Collectively, the market for preferred securities is roughly $1 trillion, a four-fold increase since 2005.

But investors must also be paid for their equity-like features, deep subordination and long duration, with higher yields than they would receive on normal corporate bonds. On a historical basis, in normal inflationary periods income for preferred shareholders has been most commonly in the 6-8% range, generally higher than both the dividend offered on the issuer’s common shares and the coupon payment on its bonds. The yield advantage to senior debt for the same issuer can be competitive with the issuer’s high yield bonds, often making the preferred class the highest yielding security for a company – and one of the highest yields within the fixed income markets.

 

Preferreds in issuer capital structure

Preferreds are a form of equity for issuers. These securities offer an ability to meet capitalization targets, particularly requirements established by regulators or ratings agencies, without diluting existing shareholders control and claim on future earnings.

Aside from paying interest rather than dividends, these securities retain other features of the preferred share class, such as deferrable coupons and long maturities.

Regulated entities, such as banks (57.2%), insurance companies (13.1%) and utilities (12.7%), represent 83% of the market. This reflects the regulatory requirement for junior capital securities. Unregulated corporates often issue interest-bearing preferred equity as they are attempting to make the issue more appealing in the eyes of ratings agency capital requirements rather than regulators, aside from paying interest rather than dividends. These securities retain other features of the preferred share class such as deferrable coupons and long maturities.

Preferred-Securities-EN-Fig05

Preferred-Securities-EN-Fig06

 

Market segmentation

A company can issue securities into either the retail or institutional market. It generally utilizes both to diversify its investor base and tap into the various sources of capital and liquidity available to it. Retail investors are often looking at absolute coupon or yield to call, and institutional investors are usually looking at preferred securities’ comparable spread over senior bonds from the same issuer or over Treasuries.

While each market segment has security structures tailored to its primary investor bases, a few securities exist that offer nearly identical credit and structural risk. Differences in technicals and value assessment driven by supply and demand in the two markets can cause substantial differences in the value of similar securities over time. Pricing discrepancies can provide active managers with the ability to move between the markets in an effort to capture value while selecting securities that seek to offer the best risk/ return profile for an investment portfolio. Exhibit 7 shows how two similar preferred securities issued in different segments of the market can diverge in price over time.

Preferred-Securities-EN-Fig07

 

Conclusion

Preferred securities shouldn’t be overlooked when evaluating opportunities. Although additive to fixed income allocations, the asset class shares characteristics with equities. Deciding where preferreds fit into a portfolio is a function of an issue’s structure, with plenty of features and associated benefits to meet an individual’s needs.

 

> download

1 Source: Allianz Global Investors, Bloomberg, based on ICE BofAML Fixed Rate Preferred Securities Index and Bloomberg Barclays US Corporate High Yield Index. Data as of 31 December 2019.  
2 Allianz Global Investors, Bloomberg, based on ICE BofAML Fixed Rate Preferred Securities Index, Bloomberg Barclays US Corporate High Yield Index and S&P Dow Jones. Data as of 31 December 2019.  

 

Five ways the coronavirus could change how we think about sustainability

07/05/2020
Five ways the coronavirus could change how we think about sustainability

Summary

The coronavirus pandemic has highlighted core sustainability issues such as income inequality, poor healthcare and complex supply chains. As a result, sustainability is likely to become increasingly integral to asset managers’ investment processes and risk analysis. Here are five ways we think the crisis will affect investors.

Key takeaways

  • Increased public demand for adequate healthcare is likely to overcome concerns about high costs, leading to widespread changes to healthcare models
  • Disruption to global trade may lead to greater focus on local communities and shorter, more controllable supply chains
  • Companies that take proactive steps to support their customers and employees during the pandemic should benefit when the crisis fades
  • Any backsliding on the progress already seen on environmental, social and governance (ESG) issues – particularly the environment and climate change – will be short-lived

Allianz Global Investors

You are leaving this website and being re-directed to the below website. This does not imply any approval or endorsement of the information by Allianz Global Investors Asia Pacific Limited contained in the redirected website nor does Allianz Global Investors Asia Pacific Limited accept any responsibility or liability in connection with this hyperlink and the information contained herein. Please keep in mind that the redirected website may contain funds and strategies not authorized for offering to the public in your jurisdiction. Besides, please also take note on the redirected website’s terms and conditions, privacy and security policies, or other legal information. By clicking “Continue”, you confirm you acknowledge the details mentioned above and would like to continue accessing the redirected website. Please click “Stay here” if you have any concerns.

Welcome to Allianz Global Investors

Select your language
  • 中文(繁體)
  • English
Select your role
  • Individual Investor
  • Intermediaries
  • Other Investors
  • Pension Investors
  • Allianz Global Investors Fund (“AGIF”)

    • Allianz Global Investors Fund (“AGIF”) as an umbrella fund under the UCITS regulations has within it different sub-funds investing in fixed income securities, equities, and derivative instruments, each with a different investment objective and/or risk profile.

    • All sub-funds (“Sub-Funds”) may invest in financial derivative instruments (“FDI”) which may expose to higher leverage, counterparty, liquidity, valuation, volatility, market and over the counter transaction risks. A Sub-Fund’s net derivative exposure may be up to 50% of its NAV. 

    • Some Sub-Funds as part of their investments may invest in any one or a combination of the instruments such as fixed income securities, emerging market securities, and/or mortgage-backed securities, asset-backed securities, property-backed securities (especially REITs) and/or structured products and/or FDI, exposing to various potential risks (including leverage, counterparty, liquidity, valuation, volatility, market, fluctuations in the value of and the rental income received in respect of the underlying property, and over the counter transaction risks). 

    • Some Sub-Funds may invest in single countries or industry sectors (in particular small/mid cap companies) which may reduce risk diversification. Some Sub-Funds are exposed to significant risks which include investment/general market, country and region, emerging market (such as Mainland China), creditworthiness/credit rating/downgrading, default, asset allocation, interest rate, volatility and liquidity, counterparty, sovereign debt, valuation, credit rating agency, company-specific, currency  (in particular RMB), RMB debt securities and Mainland China tax risks. 

    • Some Sub-Funds may invest in convertible bonds, high-yield, non-investment grade investments and unrated securities that may subject to higher risks (include volatility, loss of principal and interest, creditworthiness and downgrading, default, interest rate, general market and liquidity risks) and therefore may adversely impact the net asset value of the Sub-Funds. Convertibles will be exposed prepayment risk, equity movement and greater volatility than straight bond investments.

    • Some Sub-Funds may invest a significant portion of the assets in interest-bearing securities issued or guaranteed by a non-investment grade sovereign issuer (e.g. Philippines) and is subject to higher risks of liquidity, credit, concentration and default of the sovereign issuer as well as greater volatility and higher risk profile that may result in significant losses to the investors. 

    • Some Sub-Funds may invest in European countries. The economic and financial difficulties in Europe may get worse and adversely affect the Sub-Funds (such as increased volatility, liquidity and currency risks associated with investments in Europe).

    • Some Sub-Funds may invest in the China A-Shares market, China B-Shares market and/or debt securities directly  via the Stock Connect or the China Interbank Bond Market or Bond Connect and or other foreign access regimes and/or other permitted means and/or indirectly through all eligible instruments the qualified foreign institutional investor program regime and thus is subject to the associated risks (including quota limitations, change in rule and regulations, repatriation of the Fund’s monies, trade restrictions, clearing and settlement, China market volatility and uncertainty, China market volatility and uncertainty, potential clearing and/or settlement difficulties and, change in economic, social and political policy in the PRC and taxation Mainland China tax risks).  Investing in RMB share classes is also exposed to RMB currency risks and adverse impact on the share classes due to currency depreciation.

    • Some Sub-Funds may adopt the following strategies, Sustainable and Responsible Investment Strategy, SDG-Aligned Strategy, Sustainability Key Performance Indicator Strategy (Relative), Green Bond Strategy, Multi Asset Sustainable Strategy, Sustainability Key Performance Indicator Strategy (Absolute Threshold), Environment, Social and Governance (“ESG”) Score Strategy, and Sustainability Key Performance Indicator Strategy (Absolute). The Sub-Funds may be exposed to sustainable investment risks relating to the strategies (such as foregoing opportunities to buy certain securities when it might otherwise be advantageous to do so, selling securities when it might be disadvantageous to do so, and/or relying on information and data from third party ESG research data providers and internal analyses which may be subjective, incomplete, inaccurate or unavailable and/or reducing risk diversifications compared to broadly based funds) which may result in the Sub-Fund being more volatile and have adverse impact on the performance of the Sub-Fund and consequently adversely affect an investor’s investment in the Sub-Fund. Also, some Sub-Funds may be particularly focusing on the GHG efficiency of the investee companies rather than their financial performance which may have an adverse impact on the Fund’s performance.

    • Some Sub-Funds may invest in share class with fixed distribution percentage (Class AMf). Investors should note that fixed distribution percentage is not guaranteed. The share class is not an alternative to fixed interest paying investment. The percentage of distributions paid by these share classes is unrelated to expected or past income or returns of these share classes or the Sub-Funds. Distribution will continue even the Sub-Fund has negative returns and may adversely impact the net asset value of the Sub-Fund.  Positive distribution yield does not imply positive return.

    • Investment involves risks that could result in loss of part or entire amount of investors’ investment.

    • In making investment decisions, investors should not rely solely on this [website/material].

    Note: Dividend payments may, at the sole discretion of the Investment Manager, be made out of the Sub-Fund’s capital or effectively out of the Sub-Fund’s capital which represents a return or withdrawal of part of the amount investors originally invested and/or capital gains attributable to the original investment. This may result in an immediate decrease in the NAV per share and the capital of the Sub-Fund available for investment in the future and capital growth may be reduced, in particular for hedged share classes for which the distribution amount and NAV of any hedged share classes (HSC) may be adversely affected by differences in the interests rates of the reference currency of the HSC and the base currency of the respective Sub-Fund. Dividend payments are applicable for Class A/AM/AMg/AMi/AMgi/AQ Dis (Annually/Monthly/Quarterly distribution) and for reference only but not guaranteed.  Positive distribution yield does not imply positive return. For details, please refer to the Sub-Fund’s distribution policy disclosed in the offering documents.

     


    Allianz Global Investors Asia Fund

    • Allianz Global Investors Asia Fund (the “Trust”) is an umbrella unit trust constituted under the laws of Hong Kong pursuant to the Trust Deed. Allianz Thematic Income and Allianz Selection Income and Growth and Allianz Yield Plus Fund are the sub-funds of the Trust (each a “Sub-Fund”) investing in fixed income securities, equities and derivative instrument, each with a different investment objective and/or risk profile.

    • Some Sub-Funds are exposed to significant risks which include investment/general market, company-specific, emerging market, creditworthiness/credit rating/downgrading, default, volatility and liquidity, valuation, sovereign debt, thematic concentration, thematic-based investment strategy, counterparty, interest rate changes, country and region, asset allocation risks and currency (such as exchange controls, in particular RMB), and the adverse impact on RMB share classes due to currency depreciation.  

    • Some Sub-Funds may invest in other underlying collective schemes and exchange traded funds. Investing in exchange traded funds may expose to additional risks such as passive investment, tracking error, underlying index, trading and termination. While investing in other underlying collective schemes (“CIS”) may subject to the risks associated to such CIS. 

    • Some Sub-Funds may invest in high-yield (non-investment grade and unrated) investments and/or convertible bonds which may subject to higher risks, such as volatility, creditworthiness, default, interest rate changes, general market and liquidity risks and therefore may  adversely impact the net asset value of the Fund. Convertibles may also expose to risks such as prepayment, equity movement, and greater volatility than straight bond investments.

    • All Sub-Funds may invest in financial derivative instruments (“FDI”) which may expose to higher leverage, counterparty, liquidity, valuation, volatility, market and over the counter transaction risks.  The use of derivatives may result in losses to the Sub-Funds which are greater than the amount originally invested. A Sub-Fund’s net derivative exposure may be up to 50% of its NAV.

    • These investments may involve risks that could result in loss of part or entire amount of investors’ investment.

    • In making investment decisions, investors should not rely solely on this website.

    Note: Dividend payments may, at the sole discretion of the Investment Manager, be made out of the Sub-Fund’s income and/or capital which in the latter case represents a return or withdrawal of part of the amount investors originally invested and/or capital gains attributable to the original investment. This may result in an immediate decrease in the NAV per distribution unit and the capital of the Sub-Fund available for investment in the future and capital growth may be reduced, in particular for hedged share classes for which the distribution amount and NAV of any hedged share classes (HSC) may be adversely affected by differences in the interests rates of the reference currency of the HSC and the base currency of the Sub-Fund. Dividend payments are applicable for Class A/AM/AMg/AMi/AMgi Dis (Annually/Monthly distribution) and for reference only but not guaranteed.  Positive distribution yield does not imply positive return. For details, please refer to the Sub-Fund’s distribution policy disclosed in the offering documents.

     

Please indicate you have read and understood the Important Notice.