U.S. preferred shares sold off in Q1 2023 amid investor nervousness about deposit liquidity concerns at several U.S. regional banks (Silicon Valley Bank, Signature Bank, First Republic Bank) and Credit Suisse, a major Swiss bank. While well-capitalized by regulatory standards, these banks were unable to meet liquidity demands related to a classic run-on-the-bank, and regulators brokered a forced sale of these institutions to stronger banks.
For U.S. bank depositors, unrealized losses in investment and loan portfolios was the primary concern that led to deposit flight. These unrealized losses were almost entirely due to higher interest rates reducing the prices of U.S. Treasuries and related securities that make up the bulk of banks’ investment portfolios. The more severe asset-liability mismatches have been bank-specific and, in our view, do not represent a threat to the overall 5,000-member global banking system.
Q2 2023 earnings, reported in July, showed that earnings were in line with analyst expectations. Capital ratios remained strong and regional banks especially have generally been successful in attracting or retaining deposits. Non-interest-bearing deposits are down, in most cases replaced by more expensive interestbearing deposits, a more costly source of bank funding. Investors were generally reassured by Q2 results and U.S. bank stocks staged a minor rally after earnings season.
U.S. Regional Bank Deposit Growth
U.S. banks are major issuers of U.S. preferred securities, but there are issuers in other business sectors as well, and fundamentals appear to be solid across the board. Insurance, pipeline, telecom and utilities issuers were historically more stable and their preferred share issues provide stability and diversification to a U.S. preferred share portfolio.
With global banks slowly regaining investor confidence and with other segments of the market in good shape, we have 4 reasons why investors should consider initiating or adding to a position in U.S. preferred shares currently:
1) Yields are attractive, and are moving higher due to floating-rate resets
New issuance so far in 2023 has been more robust than in 2022, and coupons have improved over 2022. U.S. banks issued in the range of 6.25%-7.625% for their front-end coupons, with international issuers’ AT1 issues priced at 7.50%-8.50%. Back-end spreads mostly remained in the 300-400 bps range, which is attractive based on credit metrics of most issuers.
BPRF and BEPR’s exposure to currently floating-rate preferreds was another significant benefit to the portfolio over the trailing one year. As interest rates have risen over the past year and a half, these securities have been among the best performers. Most have reset formulas that are based on a spread above 3-month LIBOR (largely being replaced with SOFR), which has risen along with Fed rate hikes.
The impact of coupon resets in the portfolio has been material. The average floating-rate coupon in the portfolio has increased over the past year from 5.44% on 8/31/2022 to 8.53% on 8/31/2023 (see table above). These higher resets, along with reinvestment into new issues with higher coupons, have increased the average coupon for the entire portfolio from 6.27% to 6.88% over the same period.
2) Preferreds are trading at appealing discounts to par value
U.S. Preferreds are trading at discounts to par value not seen since the global financial crisis, with segments priced as low as 88 cents on the dollar. U.S. Preferreds typically trade near par and can sell at a premium. Current discounts represent a potentially substantial capital appreciation opportunity for investors when interest rates eventually decline.
3) Preferreds historically have provided their best returns in periods following a market correction
In many cases, returns in periods after a market correction have been in the double-digits. With preferreds still at depressed levels, the opportunity to participate is still timely.
4) U.S. Preferreds had strong performance after past interest rate hike cycles ended
We cannot be sure that the U.S. Federal Reserve has completed hiking interest rates, however market participants believe that if the Fed isn’t finished, it is very close to the end. U.S. preferred shares have a history of strong performance in periods after the end of an interest rate hike cycle.
Fixed-income markets, including the preferred market, have struggled over the last 18 months amid a historically rapid rise in interest rates. We believe that this has set the stage for U.S. Preferreds to provide investors with attractive coupons and the opportunity for capital gains over the coming periods.
Brompton’s Approach:
Brompton Flaherty & Crumrine Investment Grade Preferred ETF (BPRF, BPRF.U) and Brompton Flaherty & Crumrine Enhanced Investment Grade Preferred ETF (BEPR, BEPR.U) offer ways to invest in the U.S. preferred share market with the benefit of active management by the longest tenured U.S. preferred share specialist, Flaherty & Crumrine Incorporated.
This document is for information purposes only and does not constitute an offer to sell or a solicitation to buy the securities referred to herein. The opinions contained in this report are solely those of Brompton Funds Limited (“BFL”) and are subject to change without notice. BFL makes every effort to ensure that the information has been derived from sources believed to be reliable and accurate. However, BFL assumes no responsibility for any losses or damages, whether direct or indirect which arise from the use of this information. BFL is under no obligation to update the information contained herein. The information should not be regarded as a substitute for the exercise of your own judgment. Please read the prospectus before investing.
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Information contained in this document was published at a specific point in time. Upon publication, it is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. Certain statements contained in this document constitute forward-looking information within the meaning of Canadian securities laws. Forward-looking information may relate to matters disclosed in this document and to other matters identified in public filings relating to the funds, to the future outlook of the funds and anticipated events or results and may include statements regarding the future financial performance of the funds. In some cases, forward-looking information can be identified by terms such as “may”, “will”, “should”, “expect”, “plan”, “anticipate”, “believe”, “intend”, “estimate”, “predict”, “potential”, “continue” or other similar expressions concerning matters that are not historical facts. Actual results may vary from such forward-looking information. Investors should not place undue reliance on forward-looking statements. These forward looking statements are made as of the date hereof and we assume no obligation to update or revise them to reflect new events or circumstances.
