Preferred US banks: lower complexity than credit risk
By Andrew C. Arbesman, CFA, CPA
Preferred US banks offer investors attractive risk-adjusted returns relative to similarly rated credit.
We remain confident in the soundness of the financial system and maintain a constructive view of banking sector credit sector. Banks learned painful lessons during the financial crisis and have been de-risking their balance sheets for a decade.
Today they have higher capital requirements, strong liquidity, stable funding and lower leverage. In our view, banks are likely to remain committed to these standards, protecting both creditors and shareholders during the current period of heightened volatility and uncertainty.
Given our confidence in the US banking system, we feel comfortable reducing the banks’ capital stack for additional yield. In particular, preferred banks offer attractive risk-adjusted returns relative to similarly rated credit.
The Preferred Market was not immune to challenging market conditions in 2022. Rapidly moving rates coupled with heightened market volatility contributed to underperformance.
Yet despite negative returns so far this year, the Preferred Market has performed in line with, if not slightly better than, other markets such as BBB Corporates, BB Corporates and High Yield. Additionally, Preferred Yields look attractive, offering a significant yield boost over BBB companies, for example.
In our view, banks’ preferential yield offer is more a function of a complexity premium than credit risk. It is very rare that preferred stocks have a similar structure, with differences such as duration/extension risk, benchmark rate and reset spread.
As a result, unlike other fixed income securities, preferred shares of the same issuer can show remarkably different total returns over any given period.
Another reason favored banks offer attractive returns is the lack of dedicated investors. The base of dedicated preferred investors relative to the overall size of the preferred market is one of the most imbalanced asset classes. This can lead to greater swings in valuations during times of heightened volatility.
This volatility, however, can create investment opportunities and provides investors with exposure to strong credits in a sector benefiting from positive credit fundamentals.
For investors who can reduce the complexity of preferred shares and thereby identify superior structures while performing a solid credit analysis, U.S. bank preferred shares offer an attractive investment option to potentially realize outsized gains over a longer time horizon. long.
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