Junior-subordinated capital securities markets

Size: px

Start display at page:

Download "Junior-subordinated capital securities markets"

Diane Gilbert
5 years ago
Views:

Spectrum Asset Management Junior-subordinated capital securities markets April 2018 update The content of this article was provided by Spectrum Asset Management, Inc.

1 Spectrum Asset Management Junior-subordinated capital securities markets April 2018 update 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. Phil Jacoby, CIO Spectrum Asset Management 4 May 2018 The equity and U.S. Treasury bond markets moved modestly in different directions in April with stocks rising and bonds falling the S&P 500 rose 0.27% and U.S. Treasury long bond futures slipped 1.90%. The 30-year U.S. Treasury bond closed the month yielding 3.12% (15 basis points (bps) higher month-to-date (MTD); 38 bps higher year-to-date (YTD)) and the U.S. Treasury 10-year note closed yielding 2.95% (21 bps higher MTD; 54 bps higher YTD). The yield curve differential between the two terms closed at 17 bps (16 bps flatter on the year). There was no Federal Reserve (Fed) meeting this month, but there was Fed chatter. St. Louis Fed President, James Bullard, said that the risk of an escalating trade war between the United States and China is adding friction to an otherwise constructive economic expansion. Mr. Bullard has been concerned about inverting the yield curve, which has typically signaled an approaching end to cyclical economic expansion. The Fed has spent a great deal of time, energy, and money in order to run the economy hot and gain success on reflation. Therefore, it is unlikely it would move to invert the yield curve as a source of selfinflicted economic friction when external friction (like a trade war) is a new uncertainty (or source of drag) added to the Fed s outlook. More on this topic later, along with the implications for our investment universe. Before we discuss performance in capital securities this month, let s look at performance in some other credit markets for reference points: The junk market (measured by the ICE Bank of America Merrill Lynch High Yield h0a0 Index) rose 0.68% to close yielding 6.24% (11 bps lower). Financial credit (measured by ICE Bank of America Merrill Lynch s cf06 Index) fell 0.86% to close yielding 4.17% (17 bps higher). The BBB rated 5-to-10-year corporate sector (measured by ICE Bank of America Merrill Lynch s c6a4 Index) fell 0.85% to close yielding 4.33% (18 bps higher). Global preferred securities are a subset of a broader group of global junior-subordinated capital securities, which can be referenced by two ICE Bank of America Merrill Lynch indexes: The ICE BofA Merrill Lynch US All Capital Securities Index (i0cs) and The ICE BofA Merrill Lynch Large Cap Contingent Capital Index (cocl). Our litmus test for junior-subordinated capital securities (i.e., j-subs ) satisfies two core characteristics: Any non-payment of distributions would not accelerate an event of default (i.e., distributions are junior-subordinated to ordinary interest obligations) and, Balance sheet classification is something other than common stock under GAAP disclosure. Junior-subordinated capital securities market update April

2 The US All Capital Securities (i0cs) benchmark of preferred securities represents US$297.8 billion (face amount) of investment-grade and below-investment-grade instruments in both the retail $25 par market (43%) and the institutional $1,000 par market (57%). The face value of i0cs rose US$4.0 billion this month. The Contingent Capital (cocl) benchmark of junior-subordinated capital securities represents US$195.9 billion (face amount) of investment-grade and below-investment-grade fixed-rate instruments with contractual triggers that can subordinate them to common stock. The two indexes combine for a US$493.7 billion universe of fixed-rate junior-subordinated capital securities with preferred securities (measured by iocs) being 60% and contingent capital securities (measured by cocl) being 40%. In the preferred securities sleeve, there are four sub-component indexes in i0cs. A preferred security represents a capital security issued either through charter amendment (as a stock) or through indenture (as a bond) typically within the context of a gone-concern statutory authority (e.g., U.S. banks). As a gone concern, a company reorganization would be processed through a bankruptcy court. Preferred security payments are in priority to common stock dividends, yet can be deferred (i.e., payments are cumulative) or eliminated (i.e., payments are non-cumulative) without causing an immediate event of 22%, YTW 4.69% 31%, YTW 4.04% Fixed Rate Preferred Index (p0p1) 7%, YTW 5.81% 40%, YTW 3.06% High Yield Fixed Rate Preferred Index (p0hy) US Capital Securities Index (c0cs) default; any principal loss absorption on a preferred security would be forced only ex-post through a statutory resolution in a bankruptcy proceeding. The four sub components of i0cs preferred securities benchmark are shown to the left. Overall, the ICE BofA Merrill Lynch All US Capital Securities Index (i0cs) fell 0.49% in April to close yielding 3.93%, which was 32 bps higher than last month s closing yield and a spread of +130 bps over comparable treasury securities this was 13 bps wider than last month. The rebalancing this month added US$4.0 billion in preferred securities to the benchmark and the yield impact from the rebalancing increased the yield to worst (YTW) by 3 bps to 3.96%. High Yield Capital Securities Index (h0cs) The ICE BofA Merrill Lynch Large Cap Contingent Capital Index (cocl) rose 0.45% to close yielding 4.68%, which was 8 bps lower than last month. The rebalancing this month added US$1.6 billion in contingent capital securities to the benchmark, which helped to increase the YTW by 6 bps to 4.74%. A contingent capital security (i.e., CoCo) represents a capital security issued through indenture typically within the context of a going-concern type regulatory regime for banking, which would reorganize an insolvent bank through the contracts of its capital before falling into any conservatorship. CoCos payments are non-cumulative and pari passu to common stock dividends and can be reduced or eliminated without causing an event of default; principal loss absorption on a CoCo could be forced exante through a regulatory action in advance of any bankruptcy proceeding (which may not happen by the virtues of bail-in capital being in place). We have commented that markets often climb walls of worry and that markets need things to worry about because worry equates to trouble; and trouble can reprice risk to where we are comforted not to worry as much. The U.S. Treasury market (in particular the 2-year note) has reached a yield that can Junior-subordinated capital securities market update April

fully discount a 2.5% federal funds rate arriving by December (i.e., a total of four rate hikes). As a result, there is room for a modest summer bond rally to join up with a renewed rebound in the U.

3 fully discount a 2.5% federal funds rate arriving by December (i.e., a total of four rate hikes). As a result, there is room for a modest summer bond rally to join up with a renewed rebound in the U.S. dollar that is marginally disinflationary. This reaffirms our view for the Fed to move in June, pause in September, and move again in December. Note the graph below of the 10-year U.S. Treasury yield and the 10-year inflation protected securities (i.e., TIPS): Source: Bloomberg. Past performance is no guarantee of future results. The green line is the difference between the nominal yield of the 10-year treasury note and the real yield on 10-year TIPS in other words, it s the market s expected internal rate of inflation over the next ten years. The orange line is the real yield represented by 10-year TIPS and can represent the market s perception of deflation risks notice that in 2013 this line was negative, which is anecdotal to why the Fed aggressively used its balance sheet to print money and buy bonds. This led to the taper tantrum as nominal yields were driven too low against the backdrop of all that money creation designed to impel inflation spirits up which it did. Then commodity prices cracked in 2014 and bottomed in 2016 as TIPS (i.e., the deflation flares) triple bottomed effectively at zero. Since the U.S. election, deflation risks, expressed by TIPS yields, have been declining in anticipation of elevating fiscal expansion (and risks). Except for a pause in 2017, the inflation goals of the Fed appear to be sustainable in the near-term as the green line is again trending a pocket above 2% for the first time since 2014 (i.e., the aftermath of the taper tantrum). Junior-subordinated capital securities market update April

This sets up a visible runway to enable a soft landing for U.S. treasuries, which ought to be supportive of preferred and contingent capital securities.

4 This sets up a visible runway to enable a soft landing for U.S. treasuries, which ought to be supportive of preferred and contingent capital securities. The graph below illustrates the increases in the federal funds rate to date and how the U.S. Treasury 2-year note has a tendency to elevate ahead of Fed actions, only to eventually be caught by the persistant Fed increases: Source: Bloomberg. Past performance is no guarantee of future results The pink line (i.e., the upper bound of the target funds rate) is the developing runway which the Fed patiently builds up for the 2-year note yield to softly land upon. Indeed, for each of the past two summers this runway has been available for the 2-year note and it appears that this runway is being built again for another annual summer landing. For this to play through, the 2-year note could rally to meet the upper bound at 2.25% by September (around the same time the Trump Administration may be threatening to shut down the government again) or it could just trend sideways and meet the Fed at 2.50% by December. Our bet is on the modest summer bond rally because it appears increasingly probable that equity prices may give the Fed a little challenge by finally slipping under its 200-day moving average (for a while) as the dollar rallies to export some (needed) inflation back to Europe. Notice the green line in the graph shows a positive real rate of return is now available on the 2-year note. This opportunity cannot be ignored for too much longer as it s a first-time event for this expansion, and it signals a safe space with inflation protection for any equity investors that are looking to trim risk. We believe that our junior-subordinated income universe can be a safe space too, but with a bigger income kicker from quality financials. We remind our readers every month about the differences between preferred securities and contingent capital securities because these fundamental credit attributes guide the down-in-capital-structure yield premiums expected as income. But beyond high income in quality credits, junior-subordinated capital securities are uniquely interesting from a structural perspective that is, income can follow the term structure of interest rates higher. The core of Spectrum s strategy pivots around $1,000 par preferred securities with the relative value sector weights moving opportunistically in and out of two bookends the $25 par preferred securities sector and the contingent capital securities sector, as the case may be. So, if credit remains well anchored in the deep waters of common equity tier1 support, derisked top line growth, and adequate loss reserves (i.e., our base case ), then we should be comforted to not worry all that much about credit risks and get paid as agreed, even in a recession (i.e., although this is not our base case). The primary wall of worry for most Junior-subordinated capital securities market update April

5 investors seems to be rates risk because economic momentum appears sustainable against the backdrops of fiscal expansion and tax cuts. In conclusion, we just showed a case for a modest rally in the U.S. treasury market, but what if we are wrong (after already being right) and rates go even higher how high can rates go? Frankly, we can only make an arguable judgement call (i.e., a U.S. Treasury 10-year note yielding 3.5% before the next presidential election). But, what we know is that the structure of our portfolios are built like the structure of our cells with protein and fat, that s it. The protein is muscle from credit fundamentals and the fat is current income that can grow along with the term structure of interest rates. Fixed-to-floating and fixed-to-variable rate income structures uniquely predominate our funds and can foster elements of economic comfort not to worry as income can grow to offset the capital uncertainties of taking risks. Investment Risk Warning The potential for profit is accompanied by the possibility of loss. Investing involves risk, including possible loss of principal. 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 (Preferred securities rank junior to senior debt). International and global investing involves greater risks such as currency fluctuations, political/social instability and differing accounting standards. When interest rates rise, the price of debt and preferred securities typically declines. Non-investment grade securities offer a potentially higher yield but can carry a greater degree of risk. Contingent Capital Securities carry greater risk compared to other securities in times of credit stress. An issuer or regulator s decision to write down, write off or convert a CoCo may result in complete loss on an investment. Junior-subordinated capital securities market update April

6 Index Descriptions ICE BofA Merrill Lynch Fixed Rate Preferred Index (p0p1): comprised of IG $25 par and IG $1,000 par US AT1 ICE BofA Merrill Lynch High Yield Fixed Rate Preferred Index (p0hy): comprised of BIG $1,000 par US AT1 and BIG $25 par ICE BofA Merrill Lynch US Capital Securities Index (c0cs): comprised of IG $1,000 par hybrids (no US AT1) ICE BofA Merrill Lynch High-Yield Capital Securities Index (h0cs): comprised of BIG $1,000 par legacy Tier1 and BIG $1,000 par hybrids Disclosure Unless otherwise noted, the information in this document has been derived from sources believed to be accurate as of May 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. This material contains general information only and does not take account of any investor s investment objectives or financial situation and should not be construed as specific investment advice, recommendation or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding an investment or the markets in general. The opinions and predictions expressed are subject to change without prior 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 Global Investors and its affiliates, and their officers, directors, employees, agents, disclaim any express or implied warranty of reliability or accuracy and any responsibility arising in any way (including by reason of negligence) for errors or omissions in this document or in the information or data provided in this document. Past performance is no guarantee of future results and should not be relied upon to make an investment decision. Investing involves risk, including possible loss of principal. 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. Junior-subordinated capital securities market update April

7 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. In Europe, this document is directed exclusively at Professional Clients and Eligible Counterparties and should not be relied upon by Retail Clients (all as defined by MiFID II). Principal Global Investors is a global asset management company and strategies may be accessed from entities other than that which is issuing this document. Clients that do not directly contact with Principal Global Investors (Europe) Limited ( PGIE ) will not benefit from the protections offered by the rules and regulations of the Financial Conduct Authority, including those enacted under MiFID II. Further, where clients do contract with PGIE, PGIE may delegate management authority to affiliates that are not authorised and regulated within Europe and in any such case, the client may not benefit from all protections offered by the rules and regulations of the Financial Conduct Authority, including those enacted under MiFID II. 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). Switzerland by Principal Global Investors (Switzerland) GmbH which is authorized by the Swiss Financial Market Supervisory Authority ( FINMA ) Principal Financial Services, Inc 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 April

Junior-subordinated capital securities markets

Spectrum Asset Management Junior-subordinated capital securities markets July 2018 update The content of this article was provided by Spectrum Asset Management, Inc., an affiliate of Principal Global Investors.