The Preferred Securities and Subordinated Debt Markets

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Harold Stewart
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1 Callan Associates Inc. 600 Montgomery Street Suite 800 San Francisco, CA Main Fax Research Brief The Preferred Securities and Subordinated Debt Markets This research brief summarizes the primary types of preferred securities and highlights attributes that should be considered before investing. Preferred securities are a hybrid equity/debt instrument. Importantly, the asset class includes a variety of types and structures but is comprised primarily of hybrid securities and perpetual (no maturity), noncumulative preferred securities. Terminology can be complicated, and features vary across the many types of securities that fall under the "preferred" umbrella. The preferred space offers the potential for higher income relative to senior debt, which is appropriate given its subordinate position in the capital structure as well as other equity-like characteristics. Like fixed income, preferreds trade at a defined par amount ($25 or $1000) and have credit ratings and scheduled coupon/dividend payments. However, equity-like characteristics include perpetual or very long maturities, deep subordination and discretionary or deferrable payments. Senior Secured Debt Senior Debt Subordinated Debt Hybrids / Junior Subordinated CoCos / Traditional Preferred Stock (perpetual) Common Stock Seniority Source: Cohen & Steers Issuers of preferred securities are predominantly investment-grade companies and concentrated among banks and insurance companies. These two sectors make up 70-80% of the preferred market. Financial institutions, regulated insurance companies, and utilities receive favorable capital treatment from regulators and/or rating agencies by issuing preferred securities. Non-cumulative, perpetual preferred stock qualifies as Tier 1 Capital for banks. Tier 1 capital is a primary measure of a bank's financial strength. Other preferred securities may qualify as Tier 2 Capital, a lower quality of bank capital. "Cumulative" means that if a dividend/interest payment is skipped, it is accumulated and must be paid in the future. The issuer is typically obligated to pay all outstanding dividends before making a payment to common stockholders. If an issue is "non-cumulative," the company does not have to pay missed dividends. "Perpetual" means there is no maturity.

2 Entities also benefit from issuing preferreds as credit enhancement for senior debt without dilution of common stock. The preferred market has grown post-great Financial Crisis (GFC) as financial institutions and other companies have issued preferred securities to shore up capital and meet regulatory requirements. However, the market remains fairly small, relative to both equity and traditional fixed income. The U.S. dollar-denominated preferred market, broadly defined, is roughly $700 billion. By comparison, the U.S. high yield corporate bond market is about $1.8 trillion. The average quality of issuance of preferreds is BBB, but about 15% of the market is rated below BBB (below investment grade). Ratings for preferreds are generally several notches lower than an issuer's senior debt, reflecting their subordinated status and discretionary payments. The universe of preferred securities is broad and terminology differs across market participants. Below we show several types of securities that most active managers consider part of their opportunity set. Excluded from this are convertible preferreds, which are generally not considered as part of the universe for preferred managers given the equity sensitivity typically associated with these securities. Seniority Global DM Issuers Key Security Types Typical Key Characteristics BANKING INSURANCE BROKERAGE UTILITIES INDUSTRIALS TELECOM ENERGY Subordinated Baby Bonds Debt T2 CoCo 1000 par Jr. SubDebt Jr. SubDebt AT par Non-Deferrable Cumulative Dated Deferrable Cumulative Dated Deferrable I N C R E A S I N G S U B O R D I N A T I O N CoCo Preferreds Preferreds Non-Cumulative Perpetual Source: Spectrum Asset Management 2

3 Traditional Preferreds Traditional preferred securities lie just above common stock in the capital structure. Therefore, they have a higher claim on assets than common stockholders but fall below junior debt holders. Thus, while the issuer may have an investment grade rating for its senior debt, ratings for the preferred securities will be several notches lower. Preferred shareholders generally have no voting rights. Preferred stock is issued with a stated dividend or coupon payment that is discretionary. That said, deferral or lack of payment is rare and happens only in the case of severe financial distress. Preferred stock can be cumulative or noncumulative, but most is non-cumulative. The non-cumulative preferreds qualify for Additional Tier 1 capital for U.S. banks under Dodd-Frank. There are two forms of preferred stock. One trades on an exchange (usually NYSE) in $ value amounts and is traditionally purchased by retail investors. This segment comprises roughly $200 billion of the $700 billion market. Dividends are generally paid quarterly from after-tax income and thus may have tax benefits for retail investors. These securities are typically perpetual (no maturity) and non-cumulative. Issuers can indefinitely omit payment of dividends. They typically have five years of call protection and thereafter are callable at any time. The institutional segment of the market, also known as capital securities, trades over the counter like a corporate bond in $1,000 par value increments. Securities issued by non-u.s. entities in U.S. dollars comprise a significant portion of this market. Coupons are paid semi-annually and, increasingly, are fixedto-floating (fixed for a stated number of years, and then floating). This feature has broader appeal for institutional investors given a lower duration and some protection from rising rates. These securities generally have call protection for 10 years and if not called, they thereafter float based on the same spread at which they were initially issued and remain callable at any time. Hybrid Securities or Jr. Subordinated Debt Hybrid securities were designed to achieve the equity capital benefits of traditional preferreds, but in a less expensive format for the issuer. As junior subordinated debt, rather than stock, the payments are taxdeductible to the issuer. This segment of the market includes the legacy Trust Preferred securities that were issued in the 1990s and 2000's; they are no longer issued and are not a significant part of the market. There are a variety of other hybrid securities from non-banks issuers that fall under this category with the common attribute that they lie above traditional preferred securities but below subordinated debt in the capital structure. These generally have a maturity of 30 years (sometimes extendable to 60 years) with a call either five or ten years after issuance. 3

4 Contingent Capital Securities (CoCos) CoCos were first issued in the aftermath of the GFC and are only issued by non-u.s. banks, though many are issued in U.S. dollars. Depending upon the specific features of the security, CoCos can qualify as Additional Tier 1 (AT1) or Tier 2 (T2) capital under the Basel III regulations. To qualify as AT1 capital, CoCos must be perpetual with coupon payments that can be omitted or cancelled at the issuer s discretion. Further, CoCos absorb losses when the issuer's capital falls below a predetermined threshold (trigger). At that point, they convert to equity or reduce principal to meet the capital requirements necessary to meet the required minimum capital ratio. Most are issued by European banks to comply with Basel III. The market has grown rapidly and the US dollar portion of the market is approaching $200 billion. They generally have call protection for five or ten years if not called. Baby Bonds Baby bonds comprise a very small part of the market. A few companies have issued senior debt that trades on the NYSE with a $ value. Given this structure, it is called a "baby" bond and is generally considered to be a part of the preferred universe. They have a stated maturity of 30 years or longer with a call date in five years. Considerations There are a number of considerations that investors should bear in mind before making an allocation to preferreds. First, we believe that active management is critical. This is a complex space that requires not only credit research, but also the ability to appropriately analyze structures. Further, active managers can take advantage of arbitrage and relative value opportunities across the entire spectrum of preferreds and also achieve better diversification than one would find in passive options such as ETFs. That said, there are not many active managers that have an expertise in preferred securities and fees for active management are generally higher than for traditional fixed income, more in line with high yield or other niche "plus" sectors of the market. And benchmarking active managers can be difficult given that most benchmarks are focused on one segment of the universe. Preferreds offer higher yields than core fixed income because of the increased risk associated with the subordination and call features of these securities. As such, they should be thought of as a complement to core fixed income, similar to an allocation to high yield corporate bonds. While average quality is a bit 4

5 higher than that of the high yield corporate bond market, correlations to high yield have been fairly high over time. Notably, however, returns can differ markedly over shorter time periods and within different segments of the market. Many preferreds also have very long durations and thus significant exposure to changes in interest rates. However, there are an increasing number of fixed-to-floating rate structures in the market and these provide more protection from rising interest rates. Investors should also be aware of the industry concentration, as previously mentioned (banks and insurance companies) and, further, there may be some overlap with issuers held in a core fixed income portfolio. Some preferreds may have tax benefits for either individuals or corporations (or both), but favorable tax treatment can sometimes be reflected in the price of the bond. Finally, $1,000 par value securities are generally more liquid than exchange-traded preferred shares, but both are less liquid than traditional investment grade fixed income. Summary The preferred universe includes a broad array of security types, but the total market is small relative to fixed income or equity markets. While the potential for higher income and higher returns relative to traditional fixed income exists, the asset class can also be more volatile and has unique attributes that should be understood before investing. While we recommend active management for a preferred allocation, due diligence around a manager's capability and track record is also important. Finally, in the context of a total portfolio, preferreds should serve as a complement to core fixed income alongside or in lieu of high yield or other "plus" sectors. 5

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