2023-11-14 18:02:06 ET
Summary
- Preferred equities have performed poorly due to rising long-term interest rates, consistently paying around 1-2% more than long-term Treasuries.
- The yield of preferred equities, such as those in the PFF ETF, is not attractive compared to risk-free options like Treasury bills, which pay over 5% risk-free.
- There is a significant credit risk in the banking system, with many banks holding preferred equities at risk of being downgraded, leading to significant potential losses in PFF.
- In the event of a recession, increased credit risks would harm PFF far more than declining interest rates would benefit it due to widespread bank insolvency.
- Although long-term rates appear more stable, they may not decline in a recession if we continue to see supply-side inflation in global commodities.
Preferred equities have been among the worst asset classes to own over the past eighteen months from a risk-reward standpoint. Preferred equities operate with similarities between stocks and bonds, though they are defined as equities in the case of company liquidation. Most preferred equities, particularly those in popular ETFs like the iShares Preferred and Income Securities ETF ( PFF ), pay fixed yields perpetually. As such, a rise in long-term interest rates will usually lower the value of preferred equities because they adjust their yield for that of bonds of a similar risk profile. The extremely sharp rise in interest rates since 2022 is the primary culprit for PFF's ~25% drawdown, increasing its dividend yield from ~4.25% to ~7.15% today.
At the end of 2021, when preferred equities were around a peak valuation, I was among the few analysts with a bearish outlook. At that time, I believed that rising inflation would increase long-term interest rates and lower the value of preferred shares due to duration risk exposure. Since then, virtually all of PFF's losses have been due to increased long-term interest rates. That said, I believe its high exposure to banks is its most significant overall risk factor. Looking forward, I am relatively neutral regarding PFF's exposure to long-term interest rates. However, I feel a general lack of understanding of bank risks today continues to cause PFF to be overvalued from a credit risk standpoint.
PFF's Yield is Still Not Attractive
Given the sharp rise in interest rates, investors looking to earn a solid income have extremely good risk-reward options. Treasury bills, such as those in the SPDR® Bloomberg 1-3 Month T-Bill ETF ( BIL ), currently pay a 5.3% dividend yield, the highest Treasury bill return in over two decades. Treasury bills are fundamentally as safe as cash in a savings account. Short-term corporate securities, which are also fundamentally "cash equivalents," pay slightly higher yields, around 5.6% , as seen in the PIMCO Enhanced Short Maturity Active Exchange-Traded Fund ETF ( MINT ). Given the high yields of these risk-less investments, why would investors opt for a 7.3% yield on security with magnitudes higher volatility?
The spread between PFF's dividend and the 1-month Treasury rate is 1.6%. Historically, that spread is usually closer to 3-4%, indicating PFF is a poor risk-reward investment against cash equivalents. However, its spread to the 30-year Treasury is 2.4%, generally in line with its typical historical range. See below:
PFF is more similar to long-term Treasuries because it pays a yield in perpetuity. Although I vastly prefer Treasury bills today, those assets are unlikely to pay a 5%+ yield for much longer than five years (based on the yield curve), whereas investors can "lock in" a higher yield in PFF permanently. Even then, a steepening of the yield curve without a significant reduction in short-term rates may cause a continued increase in yields, potentially increasing PFF's duration-risk downside. See below:
In my view, we may see a recession in 2024 that does not result in interest rate reductions due to sticky supply-side inflation, mostly stemming from import costs. Historically, recessions occur around the time when the "10-2" yield curve crosses back into positive territory. An inverted curve predicts a recession, but it is actually the re-steepening that is the best indicator. That is accounted for in the " Estrella-Mishkin " recession odds model, which has accurately predicted the most significant recessions over the past forty years. Currently, that model indicates a very high 2024 recession risk that could increase long-term rates (due to curve steepening) and, more importantly, exacerbate banking credit risks.
In my view, there is a risk that PFF continues to decline due to higher interest rates. Of course, in most recessions, interest rates decline as inflationary strains slow. However, we're operating in an environment similar to the 1980s, with supply-side inflation in global commodity markets. That issue can create significant interest rate volatility that defies normal "demand-credit cycle" recessions, which most are accustomed to. Therefore, I only expect PFF to decline due to higher long-term interest rates if crude oil or other commodities rise significantly due to geopolitical changes or international economic issues, as that would increase inflation regardless of changes in US economic demand.
Credit Risk in Banks a Much Larger Issue
I believe many people are reluctant to objectively examine the facts regarding the US (and European) banking system. There is some public fear over that issue, and in many respects, fear seems to "put up the blinders" in understanding such risks. Further, there is a widespread view that the Federal Reserve will bail out the banking system. I believe that is true regarding deposits, but unlikely regarding bank equity since that is not the precedent set in 2023. Not only can the Federal Reserve not afford to bail out banks without exacerbating inflation (see result of QE since 2020), but that would also continue to enable the many "zombie banks" that have persisted since 2008.
Roughly 75% of PFF's holdings are in financial institutions, with the rest split between industrials and utilities. Of those, 53% have a "BBB" credit rating, right above "junk," while 26.1% are "BB," or the "best" among non-investment grades. Additionally, 16.1% are not rated. These credit ratings are not necessarily poor, but if an asset's credit rating falls from BBB to BB, its yield will usually spike up by ~1%. In general, credit spreads rise with recession risks, which can also be measured by the manufacturing PMI. The manufacturing PMI indicates core economic strength ahead of the GDP and is usually inversely correlated to credit spreads. Oddly, the manufacturing PMI is very low today, while credit spreads have only risen slightly. See below:
The PMI is an objective measure. If it is below 50, then that means leading US manufacturing firms are seeing declines in business activity. Other metrics, such as consumer sentiment, are subjective and do not necessarily indicate changes in consumption activity. That said, consumer sentiment is also fragile today and, like the PMI, is falling again after showing some signs of recovery. Combined with the interest-rate-driven recession risk, those facts would indicate that credit risks, particularly downgrade risks, are abnormally high today. However, excessive demand for credit-sensitive assets may be causing credit spreads to fail to account for credit risk changes. One reason may be that interest rates are much higher; thus, investors earning a 5-7% yield are not weighing credit risks as much as when rates were near zero.
The situation facing banks is more serious. As many know, banks are sitting on around $650B in total unrealized losses on securities due to duration declines (same as seen in PFF). Banks with falling deposits are realizing these losses, causing failures in some banks this year. Of course, securities only make up a small portion of a bank's total assets, as many banks also own significant fixed-rate loan positions, some of which have long maturities (such as non-agency mortgages). Accounting for that, total unrealized losses in the banking system is likely $1.7T to $2T . In my view, considering long-term rates have continued to rise since such calculations were made (March), total unrealized losses are likely closer to $2T or slightly higher today.
The issue? Banks only have ~$2.1T in total equity (including preferreds), meaning most would be bankrupt if they liquidated their portfolios or accounted at market value. Hypothetically, that is a non-issue for banks that manage to hold such assets for decades to maturity, given they have no capital needs by then. However, with the Federal Reserve removing money from the economy via QT, the trend in total deposits should inevitably be negative. Even more, given many larger retail banks continue to pay less than 1% savings rates, more people are moving money into money markets that pay 5%+, potentially exacerbating deposit trends. See below:
It is a surprise to me that we have not seen a significant rise in savings account rates or rates paid by banks to depositors. The core reason is that most US people are OK with letting the banks earn high net interest margins on their deposits, even though 5%+ yields are found in risk-free assets. In my view, this stems from the fact that many people are not accustomed to 5%+ risk-free rates and are not used to earning anything from their savings. However, as more banks offer 5%+ savings accounts (having equally zero insured deposit risk), I expect more people will move money into money markets, Treasury bills, or better banks.
That said, it would only take a few people to move enough money to create issues for the banking system. The relatively small decline in deposits we saw earlier this year led to the collapse of a handful of banks. Of course, that was when loan losses were extremely low. Now that loan losses are rising again and will likely rise much higher in a recession; many more banks could fail even without deposit outflows. Furthermore, if all banks accounted reasonably, the system would not have any positive equity today. Declining money supplies and rising loan losses will only exacerbate that issue if long-term interest rates do not fall. A continued increase in long-term interest rates would also exacerbate that issue by further decreasing fixed-rate loan and securities values.
The Bottom Line
One of the main issues I see in PFF is its dual exposure to interest rates. For one, higher long-term rates cause its value to decline directly. Additionally, higher long-term rates cause increased credit risks among banks, decreasing banks' net equity value. While the 25% of PFFs holdings that are not in banks do not have the latter risk, higher interest rates are hampering utilities ( XLU ), while the manufacturing PMI decline has a more direct impact on industrials.
Looking forward, I do not necessarily expect PFF to continue to lose value due to higher long-term rates. Although that remains a critical risk, there is a slowdown in inflation that could lower it so long as oil and other commodities do not rise. Of course, inflation may also be falling because the economy is starting to slow, as indicated by many forward-looking data points (the GDP being, by definition, a backward-looking data point). Considering banks' fundamental lack of solvency, even a slight increase in loan losses or a small decrease in deposits should be enough to increase credit risks in PFF materially.
That is not to say that I expect most US banks to fail, but I do expect most will see a credit downgrade in the event of a recession, likely increasing PFF's credit risk yield spread by 1% to 4%. That range is significant because it is difficult to say how great those strains will be until they occur; however, the lack of solvency we're seeing today certainly exacerbates credit risk potential. A 1-4% increase in PFF's yield due to a rise in credit spreads should lower its price by ~13% to ~46%. While that may seem extreme, PFF did lose over half of its value in 2007-2008, and those losses would likely have been permanent or larger if not for an immense bailout and stimulus in 2009.
Overall, I remain bearish on PFF due primarily to credit risks. That said, I would not short PFF today because a significant decline in inflation could increase its value by lowering long-term rates. Due to my view on "sticky" supply-side inflation, I believe that is unlikely; however, PFF could rebound rapidly if long-term rates fall. That said, given investors can earn a 5%+ return without taking the risk, I see no reason to dramatically increase risk for a marginally higher yield.
For further details see:
PFF: The 7.1% Yield Is Low When Investors Can Have 5.1% Risk-Free