Preferred securities: staying the course amid COVID-19


The coronavirus crisis has significantly derailed financial markets lately, and the preferred security sector is no exception. The good news? This asset class has a good track record of rebounding strongly following past periods of distress. Furthermore, banks are the largest group within this sector, and we think they are poised to weather the storm.

U.S. banks are different today

Banks constitute over half of the preferred securities universe, so their stability is critical to the sector’s outlook. While some current market conditions remind us of the 2008 financial crisis, banks have since improved their ability to weather financial storms by:

• Maintaining higher liquidity levels. As of March 2020, reserve balances with the Federal Reserve totaled $1.7 trillion, and banks had excess reserves of $1.5 trillion. At the start of 2007, reserve balances of were just $12 billion, with $9 billion of excess reserves.

• Owning more securities on their balance sheets. As of March 2020, banks owned $4 trillion in securities vs. $2 trillion at the start of 2007. And today these securities are higher quality and more liquid.

• Improving their capitalization. Bank balance sheets are significantly better capitalized: The Tier 1 Common Equity Capital Ratio (CET1 ratio) compares the bank’s risk-weighted assets to its Tier 1 Common Equity, which includes ordinary shares and retained earnings. This ratio for all FDIC-insured banks was 13.0% at the end of 2019, versus 8.1% at the end of 2006.

• Demonstrating the ability to pass rigorous regulatory stress tests. These tests were explicitly designed to simulate the performance of banks during periods of severe economic stress, like we are currently experiencing.

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Why do we have bank stress tests?

In the wake of the 2008 financial crisis, Congress passed the Dodd-Frank Act. One of its provisions requires the Federal Reserve to conduct an annual supervisory stress test, or DFAST. The stress tests project the impact of different macroeconomic scenarios on balance sheets, net income, capital levels and capital ratios. The results allow us to assess the potential effect of detrimental conditions on banks’ abilities to absorb losses while meeting credit obligations and continuing to lend.

What did the results show?

All 18 banks passed the severely adverse scenario, making 2019 the fourth year in a row that all banks passed the DFAST. The DFAST particularly focuses on the projection of the CET1 ratio.

After applying all of the severely adverse scenarios, regulators forecasted that the CET1 ratio would fall to a low of 9.2%, or over twice the minimum required CET1 ratio of 4.5%. That means that even during economic distress worse than the 2008 financial crisis, banks would have sufficient capital to continue their operations.

What about European banks?

European banks have also been improving their liquidity and capital positions. European banks must also undergo similar stress tests. In certain European jurisdictions, the capital and liquidity requirements are even more rigorous than in the U.S. In the U.K., all seven banks passed their 2019 stress tests. The European Banking Association runs its stress tests on European banks every other year, skipping 2019 and resuming in 2020. On average, European banks fared well during the 2018 exams and have only improved capital and liquidity since that time.

What do the results mean for preferred investors?

We think both U.S. and European banks are currently better capitalized and more able to withstand a severe economic shock than at any point in history. Their larger capital cushions create a bigger buffer for preferred investors. On the balance sheet, preferreds sit between common equity and unsecured debt, so the more capital banks hold, the greater the safeguard for owners of preferreds.

While the current market distress is negatively impacting the prices of assets, over longer periods of time, it is the investments’ fundamentals that drive their returns.

With the largest sector of the preferred universe well-positioned to withstand severe economic distress, we believe that asset prices can and will recover over time.

It is difficult to forecast how COVID-19 may impact the economy. However, the severity of assumptions made by the DFAST and banks’ performance show that they can withstand incredibly challenging times and should give some solace to investors.

Patient investors have been rewarded

The preferred sector has gone through periods of distress in the past, most notably during the financial crisis in 2008. While past performance is no guarantee of future results, we feel historical returns show investors are rewarded for being patient and staying invested during times of stress. The table below shows how the market tends to rebound strongly in the years following weakness.

While we acknowledge that the current period of distress in this asset class is quite challenging, long-term investors seeking income and diversification as part of their portfolio construction should take a deep breath before making any sudden moves. The strong fundamentals of the largest sector of the preferred universe provides a compelling reason to stay the course.

Bill Martin is chief investment officer and head of fixed income at Nuveen.

Sources: Federal Reserve, New York Federal Reserve, Federal Deposit Insurance Corporation, Barclays Research, Dodd-Frank Act Stress Test 2019 Results.

The ICE BofA U.S. All Capital Securities Index is a subset of the ICE BofA U.S. Corporate Index including all fixed-to-floating rate, perpetual callable and capital securities.

This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her advisers.

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

A word on risk

All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Investing in preferred securities entails certain risks, including preferred security risk, interest rate risk, income risk, credit risk, non-U.S. securities risk and concentration/non-diversification risk, among others. There are special risks associated with investing in preferred securities, including generally an absence of voting rights with respect to the issuing company unless certain events occur. Also in certain circumstances, an issuer of preferred securities may redeem the securities prior to a specified date. As with call provisions, a redemption by the issuer may negatively impact the return of the security held by an account. In addition, preferred securities are subordinated to bonds and other debt instruments in a company’s capital structure and therefore will be subject to greater credit risk than those debt instruments. Credit risk is the risk that an issuer of a security will be unable to make dividend, interest and principal payments when due. Interest rate risk is the risk that interest rates will rise, causing fixed income securities prices to fall. Income risk is the risk that the income will decline because of falling market interest rates. This can result when an account invests the proceeds from new share sales, or from matured or called fixed income securities, at market interest rates that are below the account’s current earnings rate. An investment in foreign securities entails risks such as adverse economic, political, currency, social or regulatory developments in a country including government seizure of assets, lack of liquidity and differing legal or accounting standards (non-U.S. securities risk). Preferred security investments are generally invested in a high percentage of the securities of companies principally engaged in the financial services sector, which makes these investments more susceptible to adverse economic or regulatory occurrences affecting that sector concentration/non-diversification risk). It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.

Nuveen, LLC provides investment advisory services through its investment specialists.

The information presented in these materials is believed to be materially correct as at the date hereof, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Data was taken from sources deemed reliable, but cannot guarantee its accuracy. The statements contained herein reflect opinions as of the date written and are subject to change without further notice. Nothing set out in these materials is or shall be relied upon as a promise or representation as to the past or future.

This document is not a prospectus and does not constitute an offer to the public. No public offering or advertising of investment services or securities is intended to have taken effect through the provision of these materials. It is not intended to provide specific investment advice including, without limitation, investment, financial, legal, accounting or tax advice, or to make any recommendations about suitability for any particular investor.

This information does not constitute investment research as defined under MiFID.



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