Fixed income markets have seemingly come full circle thus far in 2020. The combination of swift monetary and fiscal policy, along with an unprecedented pledge of support by the US Federal Reserve, has brought valuations and spreads across almost all fixed income sectors back to levels experienced prior to the COVID-19 Crisis. As of mid-September, the 10 Year US Treasury yield rests at 67 basis points (bps), US investment grade corporate bond spreads have compressed from the March highs of 381 basis bps down to 138 bps (just 5 points shy of long-term historic median levels), and US high yield corporate bonds have retraced nearly 90% of price losses since the March 23 low.1
Looking back over the past 5 months, many fixed income investors have profited from the Fed’s actions and subsequent recovery of asset prices. However, with recent yields reaching all-time lows and valuations near all-time highs, many investors find themselves asking a similar question they were asking in the first two months of 2020 — where do we go from here? (Or, where do we go for yield?)
Looking for opportunities in ‘non-core’ segments
As core sectors of the bond market have been bid up by the Fed’s intervention, opportunities within fixed income have presented themselves within “non-core” segments of the market. In our view, one asset class that still appears particularly attractive on a relative risk-return basis is preferreds.
As a whole, the preferred market has not directly benefited from Fed support and may still offer an opportunity to capture additional spread over Treasuries, relative to other fixed income sectors and asset classes (see chart below). Preferreds are only one of two categories listed below that were paying over 5% current yield as of mid-September, which may be an attractive income level in today’s low rate environment. High yield is the other category that paid over 5% current yield, but the preferred market achieved this yield level with an investment grade rating on average (BBB-). Preferred securities, as represented by the ICE Fixed Rate Preferred Core Plus Index, have a current yield of 5.59%, effective duration of 4.25, and average credit quality of BBB-.2
Credit health of preferreds
In addition to attractive yields and valuation, the overall credit health of the preferred market remains strong. Banks and financial institutions make up the core of the preferred securities market. These companies rely on preferred issuance to improve their capital ratios and preserve financial flexibility.
In contrast to the recession in 2008-09, the banking sector is better positioned to withstand a period of economic weakness, in our view. Due to regulatory reform enacted after the Great Financial Crisis, bank balance sheets were in much better shape going into this recession compared to the last. Across the banking sector, Tier 1 capital ratios were 31% higher and liquidity ratios were nearly 60% higher.2 Better capitalized banks have created a larger buffer to withstand possible loan losses that may occur due to declining business activity.
In addition to better balance sheets, large US banks have taken steps to ensure financial strength during the pandemic, including suspending all share repurchases. While bank earnings are expected to remain challenged until the economy reaches a stable footing, we believe bank preferreds will be supported by strong credit fundamentals and offer steady distribution income.
Looking outside banking and financial services, we also see opportunities for a diversified preferred portfolio to take advantage of the still-reasonable prices of preferred securities. Preferreds with exposure to commercial real estate, consumer spending, and energy all still offer above-average yield and total return potential. Many of these securities experienced the sharpest declines during the market sell-off in March. While economic recovery may not move in a straight line, preferred securities in non-financial sectors can offer a higher income stream and cheaper valuations while we wait for a sustainable recovery.
- Source: Bloomberg L.P. as of Sept. 15, 2020
- Source: Standard & Poor’s March 24, 2020
Blog header image: Javier Allegue Barros / Unsplash
Before investing, investors should carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the fund(s), investors should ask their advisors for a prospectus/summary prospectus or visit invesco.com.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates.
Investments focused in a particular industry, such as retail, are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.
Preferred stock generally has a preference as to dividends and liquidation over an issuer’s common stock but ranks junior to debt securities in an issuer’s capital structure. Unlike interest payments on debt securities, preferred stock dividends are payable only if declared by the issuer’s board of directors. Preferred stock also may be subject to optional or mandatory redemption provisions.
The opinions referenced above are those of the authors as of Oct. 16, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.