New York - November 27, 2023 ~ Now that inflation has subsided and Fed rate hikes are on hold, we believe that it is an excellent time to evaluate adding preferred stocks to balanced investment portfolios. Preferred stocks are particularly attractive investments after major dislocations such as the great financial crisis or the Pandemic. This occurs because the asset class usually becomes oversold with most securities trading well below par value.
Typically, par value is the price at which the securities are callable by the issuer. In a normal market, most preferreds will trade near par value, where potential upside is limited by the call feature. In dislocated markets, preferreds trade well below par, creating potential capital appreciation opportunities if stock and bond markets stabilize. Right now, $25 par listed preferred stock trades at an average price of approximately $19.80 (off approximately 20% versus par) and trade at an average yield of 7.8%.
We forecast that interest rates have topped out as inflation has continued to decline and the Fed has signaled it has completed its hiking cycle. We expect that global interest rates will continue to decline in 2024 as Europe enters a recession, which will force the ECB to cut rates in the first half of 2024. The drop in rates should cause both stocks and bonds to rally in 2024 as the US is unlikely to enter a recession due to a resilient housing sector and stable personal consumption aided by the recent 15% drop in gasoline prices. Rising stock and bonds are positive for preferred stocks as the asset class is sensitive to both stock and bond prices.
Preferred stocks are attractive long-term investments as the $25 listed preferreds are issued almost exclusively by public companies with substantial equity market capitalizations. Often the bonds of these issuers are rated investment grade with only the preferred rated below investment grade due to subordination vs. bonds. The preferred stock of public companies has very low historical default rates of only .3% vs. over 3% for high-yield bonds and .1% for investment-grade bonds. In addition, many of the issuers are in stable industries with substantial assets such as REITs, utilities, pipelines and communication companies. Historically, these stable, asset-rich companies are attractive acquisition targets for larger companies. These acquisitions can benefit preferred stock as the acquirors are likely to have superior credit ratings.
Another attractive characteristic of preferred stocks, particularly in the current market, is that a majority of the issues outstanding convert to floating rates after 5 years. As these conversions occur, the dividend rate can increase by up to 3% (i.e., from 5% to 8%) depending on where short rates were when the securities were issued compared to today’s historically high short-term rates of over 5%. When these conversions occur, the issuers often call the securities at par, which provides capital appreciation opportunities for securities purchased below par ($25). The US preferred stock index currently has approximately 30% fixed-to-float or floating. We believe that the current market environment makes it an attractive time to add to preferred stock allocations as the securities are trading well below par with attractive dividend yields, which provides capital appreciation opportunity if we are correct about the stock and bond markets stabilizing or rising. Even if the market continues to be challenged, preferred stocks have low default rates, which implies that the attractive yields currently available will be sustainable.
_______________________ 1 30-year default rates from 1990 to 2019 are sourced from Moody’s Investor Services.
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