Bank stress and preferred bonds: what now? (2023)

The preferred bond market has been hit hard recently. As banks and other financial institutions are the most common issuers of preferred stock, the recent turmoil in the banking sector has resulted in greater volatility and lower prices.

Our guidelines remain unchanged, but with some caveats. We still suggest a neutral allocation to preferred stocks, meaning investors may consider it if an investment in preferred stocks is consistent with their risk tolerance and investment time horizon. However, volatility is likely to remain elevated and further price declines are possible. While the entry point looks attractive for long-term investors, some caution is needed in the short-term.

More importantly, as we'll discuss below, security choices matter in today's environment. Senior bonds issued by large, highly rated banks have generally outperformed senior bonds issued by small and medium-sized banks, and we expect this trend to continue.

Preferential bond prices remain close to their cyclical lows. Closed at $85.7 on May 16^º, the average price of the ICE BofA Fixed Rate Preferred Bond Index is still close to its lowest level in more than 12 years. Volatility remains high as suggested by the right side of the chart below, with prices going up and down sharply over the past year. Prices initially fell last year as bond yields rose.Howhybrid investments with features of stocks and bonds, the long maturities (or no maturities) of senior bonds make them very sensitive to changes in interest rates. Prices fell last year as 10-year Treasury yields jumped more than two percentage points.

The recent volatility, however, is more related to the concerns of the banking sector triggered by the collapse of Silicon Valley Bank and Signature Bank in early March. Given that banks represent a large portion of the market, preferred investors seem to be concerned that further bank failures could hurt the market. Since many preferred banks are considered a form of equity, preferred investors will be left with little recovery value if the issuer fails.

Large US banks have generally outperformed small and regional banks following recent bank failures in both common stock and preferred stock markets. The key issue that led to the recent bankruptcies was the amount of deposits held by banks relative to the value of their bonds. Banks generally invest deposits in investments with a higher rate of return. But due to rising interest rates over the past year, the value of many of these bond investments has fallen, but the value of deposits has not. This is a risk if many of the bank's customers want to withdraw their deposits at the same time, as the value of the bank's investments may not be sufficient to cover these withdrawals.

Given this risk, common stocks of small and medium-sized regional banks performed below the broad bank's stock market index. The chart below compares the annual total return of the broad S&P 500 Banks Industry Group Index with the KBW regional banking index.

To evaluate the performance of preferred stocks, we select securities based on the following criteria:

• Moody's rating of Ba3 or higher, or Standard and Poor's rating of BB- or higher¹
• Nominal amounts of $25, $50 or $100
• Outstanding $100 million or more
• Denominated in US dollars
• Issued by banks and various financial institutions

The scatter chart below compares the total returns of individual preferred stocks that meet the above criteria with the size of the issuing bank, taking into account the issuer's total assets. The results are consistent with the stock chart above, where regional banks generally underperform the broad bank stock market index.

In this chart, year-to-date total returns are shown on the Y-axis and total assets of the issuing banks on the X-axis. The bubbles represent each preferred security, and the size of the bubble represents the size of each issue relative to the others. For example, the largest bubbles represent preferred issuances of more than $2 billion, while the smaller bubbles represent issuances of up to $100 million.

This year, preference shares issued by banks with the most assets performed best. For the bonds included in the screen, all senior bonds issued by a bank with at least $1 trillion in assets showed a positive cumulative return this year. When we look at small and medium-sized banks, on the left side of the chart, the dispersion of total returns is much wider, and the negative yield sizes of some issuers have been accentuated. Finally, preferred stocks, which have relatively small amounts outstanding, were among the worst performers, as illustrated by the size of the bubbles.

Most importantly, make sure any investments in your preferred securities are within your risk tolerance. In general, they should be considered moderate to aggressive risk investments due to the high interest rate and credit risk (risk that the issuer will default on interest or principal payments). For more conservative investors looking for income today, we prefer investment grade corporate bonds. For investors who are willing to take more risks for higher returns, high-rated senior bonds look more attractive than high-yield bonds. If the economy slows as we expect, high-yield bond prices could fall sharply, but preferred stocks issued by large, highly rated US banks may hold their value better.

If you're considering preferred stock, those issued by large, highly rated banks seem to be the most attractive right now. While their prices have generally held higher than the senior securities issued by small and medium-sized banks, meaning their yields are likely to be lower, they should be a bit more defensive if bank turmoil remains a short-term risk.

Investors who own individual preferred stocks should always pay attention to the characteristics of any preferred stocks they are considering, not just those with the highest returns. If specified title - preferred or not—offers a significantly higher return than similar securities, there is likely to be additional risk associated with that issue or issuer.

Finally, given the bifurcated nature of the market recently, an active management approach such as a mutual fund or separately managed account may make sense. With an active strategy, the portfolio manager can decide what to keep – or more importantly in today's environment, what not to keep.