PFFV - Preferred And Capital Securities: A Market Dislocation Opportunity

2023-04-04 11:26:00 ET

Summary

• The recent banking crisis created significant turmoil in several markets, including preferred and capital securities.
• Yet, with the crisis seemingly now contained, the extra risk attached to the hybrid assets is likely overdone, creating a compelling investment case.
• These assets now offer a yield advantage over core bonds and have a more attractive risk profile than high yield.

The recent failure of three U.S. banks has unnerved the preferred and capital securities market. However, with spreads near their highest in the last decade, coupled with new regulatory support that helps limit the risk of banking crisis contagion, now could be an attractive entry point to the asset class.

Investment grade $1,000 par spreads ICE BofA ML U.S. Investment Grade Institutional Capital Securities Index spread-to-worst vs. gov’t, last ten years

Source: Bloomberg, Principal Asset Management. Data as of March 30, 2023.

The recent banking crisis created significant turmoil in several markets, including preferred and capital securities - hybrid securities that have features of both stocks and bonds and sit between the two in the capital structure. Yet, with the crisis seemingly now contained, the extra risk attached to the hybrid assets is likely overdone, creating a compelling investment case:

1. The three U.S. banks that collapsed were unique to the broader banking sector - and the risks have been further reduced by recent federal regulatory support and a new Federal Reserve lending program.
2. The decision by Swiss regulators to wipe out Credit Suisse' ( CS ) Additional Tier 1 (AT1) bondholders ahead of equityholders in the UBS merger initially had the market perplexed, triggering significant selling of the AT1 and contingent capital (CoCo) market. However, European regulators have since confirmed that, for banks outside Switzerland, AT1 bonds only take losses after equityholders, thereby removing a key source of investor concern.
3. Following the banking crisis, yields are near their highest levels in more than 10 years, and spreads to yields on risk-free Treasurys are historically wide.

Investors may want to consider taking advantage of this market dislocation, as these assets now offer a yield advantage over core bonds and, with regulators and policymakers intent on containing banking sector risks, have a more attractive risk profile than high yield.

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