Junior-subordinated capital securities markets

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1 Spectrum Asset Management Junior-subordinated capital securities markets 2018 Outlook Regulatory Risk Warnings When interest rates rise, the price of debt and preferred securities typically declines. Preferred securities rank junior to senior debt. Non-investment grade securities offer a potentially higher yield but carry a greater degree of risk. The potential for profit is accompanied by the possibility of loss. The content of this article was provided by Spectrum Asset Management, Inc., an affiliate of Principal Global Investors. Spectrum is a leading manager of institutional and retail preferred securities portfolios. In last year s outlook, we tried to put some perspective on Donald Trump s election as U.S. president and foretell some implications of anticipated policy changes. We expected President Trump to be a supply side economic pusher and a government waste disposer and for Congress to assist in changing public policy. We viewed the U.S. election outcome as signaling the apex to the protracted long-term bull market in U.S. Treasury bonds a climax due not only to higher future inflation outcomes, but also higher real rates. Ultimately, markets should be able to price the cost of money rather than having its price controlled by the U.S. Federal Reserve Bank (Fed). Last year, we expected the implication for longer-term treasury rates after the election to be a move modestly higher by the end of 2017 a move to 2.95% on the Treasury 10-year note and 3.60% on the Treasury 30-year bond. Here s a look at what happened with a view to both the change to the U.S. yield curve and the change in the German yield curve: Junior-subordinated capital securities market update 2018 Outlook 1

2 Clearly, yields moved up with the United States showing the biggest move accentuated on the front end. But, the long end of the market basically stood still for the U.S. Treasury 10-year note while the 30-year bond rallied that was quite a twist. As the graph below shows, the U.S. 10-year Treasury note rallied (as the yield went down) into the third quarter by what appears to be a chill of deflation despite the relentless rise in equities: Here s what the Fed said: This increase in the target range was viewed as appropriate in light of the considerable progress that had been made toward the Committee s objective of maximum employment and, in view of the rise in inflation since earlier in the year, the Committee s confidence that inflation would rise to 2 percent in the medium term. That was its rationale for its move in December 2016 notice that the 10-year TIPS breakeven rate elevated to 2% by the time the Fed finally moved. Over the course of 2017, the market s view on inflation grew doubtful, but the Fed still pushed rates up three times as we expected perhaps aided by the steady jubilee in the S&P 500. But as the graph shows, by the end of the year the market s inflation expectation of 1.98% was again reasonably aligned with the Fed s 2% objective. No doubt, the hurricane related disruptions dampened the inflation cheer despite a Fed policy that remained accommodative, overall. Junior-subordinated capital securities market update 2018 Outlook 2

3 More recently the Fed outlook states that it s path (to higher rates) is not altered and that labor market conditions are indeed supported by accommodative monetary policy. We believe this to be affirmation that the Fed will again go slow on raising rates in As we pointed out last year, the Fed is doing a twist of its own in its dots report notice how projections for 2018 have been on the decline since So, as the Fed has actively raised the target federal funds rate (five times) to 1.50% on the upper band, it has also lowered its forward expectations for the rate to go much higher by reducing the forward expectation by 1.25% (i.e., from 3.375% down to 2.125%). Junior-subordinated capital securities market update 2018 Outlook 3

4 Looking beyond this year and into 2019, the Fed s twisting trend continues to show a low and slow pace to be expected by the new Federal Reserve Bank Chairman, Jerome Powell, who takes office next month: Junior-subordinated capital securities market update 2018 Outlook 4

5 All said, the Fed is guiding expectations for another two to three hikes this year and then perhaps to a softer finish by 2019 with two hikes, while coincidentally needing to manage expectations for tapering bond reinvestments on its balance sheet. What s interesting about the Fed taper, is how it will interplay with the European Central Bank s (ECB) skill to manage its own taper over the next few years and how the Fed s balance sheet and the ECB s balance sheet have been trading places over the years in a mirror image: U.S. bond yields (shown above) have arrowed-pointers to show they have risen in response to the Fed s quantitative easing or balance sheet growth. This reaction implies that the U.S. bond market is confident in the Fed eventually getting what the Fed wants that is, inflation! The European Central Bank still has some work to do though. It knows that if the money creation stops too soon, it could mean deflation risks will return. This is a lingering concern for Mario Draghi who is winding down his term (2019) and seeking to gain success on inflation for his legacy. Junior-subordinated capital securities market update 2018 Outlook 5

6 The following picture adds inflation to the bottom panel and shortens up the period to reflect just this expansion cycle: Real rates have been squeezed to extraordinarily low yields as bonds have stayed almost sideways over the past two years and inflation has risen taking the measures from this graph, real rates in the United States have declined from 2% to 0.20% over the past two years; in Europe, real rates have declined from 0.50% to -0.98% over the past two years. The pressure on higher real rates has come from the stubborn lack of inflation, which has been a catalyst for more money creation through quantitative easing. In prior cycles, real rates have been generally equal to the expected inflation rates. If this were to hold true this time, nominal 10-year yields would be considerably higher say, 4% in the United States and 3% in the Eurozone. But as the graph on page-3 showed, central bank balance sheets have been the primary tool used to down-regulate interest rates so fiscal excess can continue to grow our way to prosperity until the inflation war is won this is why we believe that there is risk to the upside in real U.S. Treasury bond rates even if inflation is muted (i.e., 2% inflation), which means that real yields should be the primary driver of the term structure of interest rates rather than the conventional view of inflation being the only reason yields can go higher. In other words, once the market believes that 2% inflation is sustainable, real yields will begin to reflect this by going higher this means a move up in nominal yields as the Fed gradually steps back on reinvestment (and the ECB tapers) and allows the private markets to absorb deficit spending. In the United States, the national debt has grown by US$11.3 trillion since the prior economic peak of October 2007 since then, U.S. government debt has grown by 8.3% Junior-subordinated capital securities market update 2018 Outlook 6

7 per year compared to 5.5% growth per year for the S&P 500. This statistic is even more startling when the period is extended back to the Clinton Administration: Since the turn of the century (Y2K), the S&P 500 has grown by an annual rate of 3.4% while the U.S. National Debt has grown by 7.3% clearly, we are a debt based society (and so is the rest of the developed world) and the central bank printing presses assist nations in funding local debt. Stubborn inflation (and even deflation) has impelled the central banks to buy debt yields down and supply markets with currency for financial asset consumption to achieve the macro-goal of inflation. But, consumption through debt pulls ahead demand from tomorrow for consumption today. So rather than saving your money to purchase later, you borrow to spend today this is the basic mindset of the developed world. Therefore, the process of currency creation simply cannot stop because a growing exchange medium is needed to buy the growing debt that our global financial system relies on as its lifeblood. So, reduction in the Fed s balance sheet will be a very slow process the same goes for the European Central Bank and its balance sheet. This puts a rather challenging longer-term technical dynamic into the markets, in that, short-term debt cycles of economic expansions are coming to cross-roads with the long-term debt cycle of simply too much national debt well, eventually anyway. The chart above also highlights how reliant equity rallies appear to be on the expansion of national debt. Consequently, a Jerome Powell led Fed may eventually turn to concerns of an asset Junior-subordinated capital securities market update 2018 Outlook 7

8 bubble (a renewal of exuberance, but exuberance gone rational not irrational) as further support to tighten despite low inflation. There is much concern over the flattening yield curve because it indicates that the Fed is trying to slow down growth to contain inflation engendered by growth. This is the usual pattern for the Fed and the economic cycle. But this economic cycle is not normal normal would mean expansion of credit indirectly through the local banking system. But this expansion has been primarily pushed through the expansion of credit directly through the quantitative easing system. Long-term real rates have collapsed (abnormally) in the process, so it s long-term real rates that should gradually rise as the United States and the European central bank balance sheets gradually unwind the implication here is for the yield curve to steepen in the process rather than flatten as conventional wisdom believes. Financial conditions are indeed exuberant. The chart below shows the Bloomberg Financial Conditions Index (BFCIUS) and the path of 10-year BBB rated corporate bond spreads: As we noted last year, the peak in the financial conditions index was +1.0 in mid-2014 when equities rallied steadily into the Fed s taper of QE-3 this was a tremendous year for preferred securities (i0cs +12%) and for bonds (Treasury 10-year +10.7%) as rates declined and preferred securities spreads tightened a Fed hike was nowhere in sight at the time, so most of the performance in preferred securities came from duration (i.e., the price move up from the yield move down). Our sense coming into 2017 was that U.S. BBB corporate bond spreads should tighten by another 40 bps as it turns out, they tightened by about 50 bps. The negative correlation between BBB corporate bond Junior-subordinated capital securities market update 2018 Outlook 8

9 spreads and the financial conditions index was even more dramatic in 2017 than it was in 2014 this was a rational response as tighter spreads foretold improving operating performance and improved operating performance is the product of an improved business environment which itself, fosters reduced equity volatility. In fact, 2017 was the first year on record that the sequence of month-over-month total return for the S&P 500 did not decline once we can say the same for the investment grade $25 par market, which too did not decline once. Indeed, last year was a tremendous year for preferred securities (i0cs +10.6%) and a coupon-clip year for bonds (Treasury 10-year +2.10%) as rates went sideways and spreads tightened significantly most of the performance in preferred securities came from spread duration or in other words, a bull tightener that went beyond our expectations. Now, we look to 2018 and frame it up by another look at financial conditions. The graph below shows the financial conditions (in green) for the Eurozone normalized against U.S. financial conditions (gold) and BBB corporate spreads (white): Junior-subordinated capital securities market update 2018 Outlook 9

10 Based on the lagging financial conditions in the Eurozone compared to the United States and the continued bond buying by the ECB this year (and perhaps even longer given Chairman Draghi s determination), we expect European bank shares to do well this year and for Euro financial spreads to outperform U.S. financial spreads because of the ECB s determination to achieve success through extended quantitative easing. As the graph below shows, the ECB has a little work to do yet to claim success if Euro financials compared to U.S. financials are a litmus: This time next year we expect the gap between European financial conditions and U.S. financial conditions to be tighter as an expression of outperformance in European spreads based on European bank equities doing well. Junior-subordinated capital securities market update 2018 Outlook 10

11 Now, let s transport these observations to an outlook for the junior-subordinated capital securities markets. We ll start with the contingent capital securities sector measured by the ICE Bank of America Merrill Lynch Contingent Capital Index (coco) and compare it to European financials using the ICE Bank of America Merrill Lynch Euro Financial Index (eb03). We use the Euro based index because the contingent capital market is comprised primarily of European bank CoCos. Below is a graph of their relative spread moves last year: There was downward spread progression in both sectors with the CoCo sector tightening 131 bps and the financial sector of European corporates tightening 45 bps. The CoCo sector tightening looks nominally more impressive, which is normal given the sector s subordination, but on an indexed basis, coco spreads finished the year at 3.16x the eb03, which was marginally lower than where it started the year at 3.29x the eb03. Even when European bank shares plummeted in early 2016, the general indexed relationship of the coco/eb00 spread held close by at 3.35x, which implies that the subordinated relationship of CoCos to European financials is roughly 3.2:1. So, the question becomes, are you bullish or bearish on European financial spreads? Whichever side you take, it appears that you can get a little better than 3:1 leverage in spread duration with CoCos. Given our positive view toward the progression of European financial conditions and likely upside in European bank stocks, European financials can tighten another 15 bps, which means CoCos should tighten by roughly 50 bps more in In the preferred securities sector of junior-subordinated capital securities, we will use a custom index (STB0) as a proxy for the preferred securities spreads instead of the ICE Bank of America Merrill Lynch US All Capital Securities Index (i0cs) because the i0cs Junior-subordinated capital securities market update 2018 Outlook 11

12 index spreads were altered last March by the methodology change. Our custom index represents preferred securities that are not $25 pars and are not CoCos basically, STBO represents the non-coco institutional $1,000 par sector. We will also use the ICE Bank of America Merrill Lynch 5-10 year BBB US Corporate Index (c6a4) as a proxy for Bloomberg s measure of BBB corporate spreads. Preferred securities have tightened rather impressively over the course of 2017 and have reached a point that we consider to be fair value relative to BBB corporate bond spreads. In our opinion, most of the relative spread tightening to corporates is done, so the primary attraction of preferred securities relative to corporates is the spread carry of about 75 bps. As we expect the equity market to do well in keeping with continued robust overall financial conditions in the United States, absolute spreads in preferred securities have room to tighten by another 20 bps. Junior-subordinated capital securities market update 2018 Outlook 12

13 When the $1,000 par sector is compared to the $25 par sector, there is a stark spread differential in favor of the institutional market, which is why we favor active management in the $25 par sector over passive plays: In conclusion, CoCos represent a plus component to the preferred securities sector as CoCos yield 100 bps more relative to institutional preferred securities measured by our custom benchmark (STB0). We expect the CoCo segment of the junior-subordinated capital securities sector to outperform the preferred securities sector because of the relative spread advantage and our expectation for European bank stocks to do well this year with more room for spreads to tighten in Europe than in the United States. The $1,000 par preferred securities sector, though a fair value relative to BBB corporate bonds, looks relatively attractive to the $25 par sector where negative convexity risk appears elevated due to an overdue U.S. equity correction. The confluence of the Fed and the ECB both reducing and tapering their balance sheet should elevate real yields on government bonds we expect the U.S. Treasury 10-year note yield to rise this year to 2.95% and the U.S. Treasury 30-year bond yield to rise to 3.35%. This should translate into a flatter yield curve, but not a flat yield curve as the hard stop on federal funds should be 2.25% this year, with the risk being just 2%. Sector selection in junior-subordinated capital securities will be important in addition to active management of structural risks. Junior-subordinated capital securities market update 2018 Outlook 13

14 We expect volatility to pick up given the maturity and decline of quantitative easing, which will gradually recede the flood of liquidity that the markets have become so accustomed to relying on. Spreads, which appear to have good momentum to start the year, should have an initial move tighter into May. The risk is that they correct along with equity as markets digest further rate increases, the new U.S. Fed regime under Jerome Powell and the eventual elimination of marginal purchases from the ECB. Overall, we expect a positive year in preferred securities, but periods of negative returns too, as spreads are already well advanced in an economic cycle that is due for a soft landing. Phil Jacoby, CIO Spectrum Asset Management 10 January 2018 Junior-subordinated capital securities market update 2018 Outlook 14

15 Index Descriptions ICE Merrill Lynch Fixed Rate Preferred Index (p0p1): comprised of IG $25par and IG $1,000 par US AT1 ICE Merrill Lynch High Yield Fixed Rate Preferred Index (p0hy): comprised of BIG $1,000 par US AT1 and BIG $25 par ICE Merrill Lynch US Capital Securities Index (c0cs): comprised of IG $1,000 par hybrids (no US AT1) ICE Merrill Lynch High-Yield Capital Securities Index (h0cs): comprised of BIG $1,000par legacy Tier1 and BIG $1,000par hybrids Disclosure Unless otherwise noted, the information in this document has been derived from sources believed to be accurate as of January Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity. Past performance is not necessarily indicative or a guarantee of future performance and should not be relied upon as a significant basis for an investment decision. Investing involves risk, and investors must be prepared to bear capital losses which might result from investments. The potential for profit is accompanied by the possibility of loss. The information in this document contains general information only on investment matters. It does not take account of any investor s investment objectives, particular needs or financial situation and should not be construed as specific investment advice, an opinion or recommendation or be relied on in any way as a guarantee, promise, forecast or guarantee of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that Principal Global Investors or its affiliates has recommended a specific security for any client account. Subject to any contrary provisions of applicable law, Principal Financial Group, Inc., Its affiliates, and its officers, directors, employees, agents, disclaim any express or implied warranty of reliability or accuracy (including by reason of negligence) arising out of any for error or omission in this document or in the information or data provided in this document. Any representations, example, or data not specifically attributed to a third party herein, has been calculated by, and can be attributed to Principal Global Investors. Principal Global Investors disclaims any and all express or implied warranties of reliability or accuracy arising out of any for error or omission attributable to any third-party representation, example, or data provided herein. All figures shown in this document are in U.S. dollars unless otherwise noted. Indices are unmanaged and do not take into account fees, expenses and transaction costs and it is not possible to invest directly in an index. This document is issued in: Europe by Principal Global Investors (Europe) Limited, Level 1, 1 Wood Street, London EC2V 7JB, registered in England, No , which has approved its contents, and which is authorised and regulated by the Financial Conduct Authority. The United States by Principal Global Investors, LLC, which is regulated by the U.S. Securities and Exchange Commission. Singapore by Principal Global Investors (Singapore) Limited (ACRA Reg. No H), which is regulated by the Monetary Authority of Singapore and is directed exclusively at institutional investors as defined by the Securities and Futures Act (Chapter 289). Hong Kong by Principal Global Investors (Hong Kong) Limited, which is regulated by the Securities and Futures Commission and is directed exclusively at professional investors as defined by the Securities and Futures Ordinance. This document is issued by Principal Global Investors LLC; a branch registered in the Dubai International Financial Centre and authorized by the Dubai Financial Services Authority as a representative office and is delivered on an individual basis to the recipient and should not be passed on or otherwise distributed by the recipient to any other person or organization. This document is intended for sophisticated institutional and professional investors only. Australia by Principal Global Investors (Australia) Limited (ABN , AFS License No ), which is regulated by the Australian Securities and Investment Commission and is only directed at wholesale investors (as defined in sections 761G and 761GA of the Corporations Act). Singapore by Principal Global Investors (Singapore) Limited (ACRA Reg. No H), which is regulated by the Monetary Authority of Singapore and is directed exclusively at institutional investors as defined by the Securities and Futures Act (Chapter 289). Switzerland by Principal Global Investors (Switzerland) GmbH which is authorized by the Swiss Financial Market Supervisory Authority ( FINMA ). Junior-subordinated capital securities market update 2018 Outlook 15

16 Risks of preferred securities differ from risks inherent in other investments. In particular, in a bankruptcy preferred securities are senior to common stock but subordinate to other corporate debt. International and global investing involves greater risks such as currency fluctuations, political/social instability and differing accounting standards. CoCos may have substantially greater risk than other securities in times of financial stress. An issuer or regulator s decision to write down, write off or convert a CoCo may result in complete loss on an investment. In Europe, this document is directly exclusively at Professional Clients and Eligible Counterparties and should not be relied upon by Retail Clients (all as defined by MiFID). In connection with its management of client portfolios, Principal Global Investors (Europe) Limited may delegate management authority to affiliates that are not authorised and regulated within Europe. In any such case, the client may not benefit from all protections offered by rules and regulations enacted under MiFID Principal Financial Services, Inc. Principal, Principal and symbol design and Principal Financial Group are registered trademarks and service marks of Principal Financial Services, Inc., a Principal Financial Group company. Principal Global Investors leads global asset management at Principal MM / Junior-subordinated capital securities market update 2018 Outlook 16