New York, NY, June 27, 2023 (5 Min Read) ~ Both preferred stocks and high yield bonds have experienced a decline in value (exchange listed price) during the Federal Reserve's tightening cycle. Preferred stocks have underperformed high yield bonds and in our view currently present an appealing relative valuation. Since December 31, 2021, the S&P Preferred Stock Total Return Index has underperformed the Bloomberg U.S. Corporate High Yield Index by 7.80%. We believe that active managers can find opportunities to purchase oversold preferred securities that may offer better risk/reward profiles than U.S. corporate high yield bonds.
For example, preferred stocks with equivalent credit ratings are trading at an average premium of 1.20% above high yield bonds, as shown in Table 1 below. Preferred stocks generally exhibit attractive credit characteristics as most preferred stock issuers are publicly traded companies committed to maintaining their credit ratings. These companies tend to employ strategies such as issuing equity, selling assets, or reducing common dividends to maintain their credit quality.
An additional advantage of preferred stocks, when compared to high yield bonds, is that many preferred stocks transition from fixed rates to floating rates after a period of 5 years. In the current interest rate environment, where short-term rates have significantly risen over the last five years, the conversion to floating rates leads to a substantial increase in the dividend rate. As a result, management of the issuer may be incentivized to call the security to avoid paying a higher dividend rate, thereby presenting an opportunity for capital appreciation. To provide an example of the initial impact, SCE Preferred H converts from a fixed coupon of 5.75% to 3-month SOFR + 3.25%. Based on the 3-month SOFR as of May 31, 2023, this conversion equates to a current yield rise from 6.3% to 9.4%, representing a more than 45% increase in the dividend.
Given the Federal Reserve's upcoming pause in rate hikes, we believe it is an opportune time to consider adding higher spread fixed income assets, such as preferred stocks and high yield bonds. Our analysis suggests that preferred stocks could potentially outperform high yield bonds in the next 2-3 years, considering their discounted valuation relative to historical averages and their decline during the recent downturn.
If you have any questions or would like to discuss further, please contact Craig Starr at Craig.Starr@icmllc.com or 212-763-8336.
*Information and underlying data are sourced from Bloomberg as of 5/31/2023. The S&P U.S. Preferred Stock Index (SPPREF) is a benchmark representing the U.S. Preferred stock market. Preferred stocks are a class of capital stock that pays dividends at a specified rate and has a preference over common stock in the payment of dividends and the liquidation of assets. The opinions represented above are subject to change and should not be considered investment advice. This data was prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed.