A Primer on Preferred Securities by Columbia Management
As financial institutions raise capital and reduce risk, preferred securities can offer an attractive risk-adjusted yield in a low-yield environment. Let’s examine this asset class, including the structures, the motivation of issuers and investors and why we think preferred securities make sense in the current market environment.
What is a preferred security?
Preferred securities carry attributes of both debt and equity securities. Preferred securities rank higher in the capital structure relative to common equity, as they have a priority claim on dividend payments and a higher claim on assets in a bankruptcy. Preferred securities generally offer higher yields than senior unsecured debt from the same issuer, reflecting their junior position in the capital structure, as well as the issuer’s ability to suspend or defer payment. These instruments can have long or perpetual maturities, and they can offer tax advantages to both the issuer and the holder. There are several different forms of preferred securities, with some targeted for institutional investors and others for retail. Before investing in the space, you need to understand the various structures, tax implications and, most importantly, the creditworthiness of the issuers.
The financial markets have traditionally treated preferred securities more like bonds than equities. The underwriting and secondary trading of these instruments falls within the bond/fixed income departments of security dealers, and the majority of institutional structures are held by bond investors. While there are many different forms of these securities, the most relevant categories include:
• Debt-based hybrid instruments have characteristics of both debt and equity. These hybrids, introduced in the mid-1990s, rank as junior subordinated obligations within the capital structure, and are always ahead of common equity and traditional preferred securities. The newest generation of hybrid structure typically start out as fixed-rate bonds for a set period and then transition to floating rate payments following a call date.
• Traditional preferred securities are perpetual securities that rank ahead of common shares and behind all other debt. These securities are typically held by retail investors and usually trade over the counter. Historically, they have been denominated in shares, issued at $25 per share. More recently, institutional interest in these securities has supported the creation of $1,000 denominated (bond like) securities.
• Contingent Convertible Securities (CoCo) are the newest form of preferred securities which came out of the requirement by bank regulators to create securities that were truly loss absorbing. The structure of the CoCos is shaped by their primary purpose as a source of building capital in times of crisis. To achieve this objective they need to automatically absorb losses prior to or at the point of insolvency and the loss absorption mechanism must be tied to the capitalization of the issuing banks. These securities are the riskiest forms of the preferred structures, and investors must be comfortable with both the debt and equity of the issuer, as the capital position of the underlying company is directly tied to these securities. Within the CoCo securities various structures exist, as some actually have final maturities and are cumulative, while others are non-cumulative and perpetual. Up to this point, they have only been issued by non-U.S. banks.
Why do companies issue preferred securities?
• Primarily financial institutions raise capital in the preferred market as regulatory requirements mandate a certain level of Tier I capital (common equity and perpetual non-cumulative preferred securities) to support liabilities.
• Preferred securities typically viewed by issuers as a cheaper/less dilutive alternative to common equity.
• Certain structures are given equity credit by the ratings agencies.
• For certain structures, payments are deductible as an interest expense.
Why do investors buy them?
• Investors primarily view preferred securities as a way to buy a high quality company and receive an enhanced yield relative to the senior unsecured debt. Currently, the yield on traditional preferred securities is 200 to 250 basis points above the yield of senior unsecured paper.
• U.S. corporations can deduct 70% of income received on certain preferred securities (DRD Preferred securities).
• Individuals pay a maximum statutory rate of 20% on qualified dividend income (QDI) distributions, relative to the maximum rate of 39.6% on ordinary income, which is the category that most bond income falls into.
• As a security that straddles the line between fixed income and equity, preferred securities provide diversification to core fixed-income portfolios, which can be very interest rate sensitive. Additionally, since many securities have fixed-to-float or pure floating rate structures, the coupons will increase with rates, providing a hedge against a rising rate environment.
How do we find value in the preferred market?
Given the nuances of the preferred market, we find that investors who are equipped to analyze and trade these structures can find attractive relative value opportunities. Our analysis begins with a thorough bottom-up credit analysis of the individual issuers, followed by quantitative modeling of the unique structural features of the deal, incorporating assumptions for forward LIBOR rates and future call or default scenarios. As a long-term active participant in this market, we have also developed expertise in trading these unique instruments, which sometimes requires involvement with various divisions within both the domestic and overseas desks of our trading counterparties.
Source: BAML, December 2013. Past performance does not guarantee future results.
Exhibit 2 is an example of the various debt offerings across the capital structure for several banks. On one side of the risk spectrum we have senior bonds, which hold priority to the other security types. As we move further down the capital stack, investors can receive a much higher yield, but at the expense of additional risk, as illustrated by the credit ratings.
Source: Columbia Management investment Advisers, LLC, December 2013