Top of the Morning: Preferred Securities - Performance & positioning
The desk argues that the recent upgrade of the Preferred Securities sector to Attractive reflects a significant opportunity in the market, particularly in the $25 par retail preferred subsector. Per the full note, Frank Sileo highlighted the compelling features of this sector, noting potential tactical rebounds amidst a supportive interest rate environment. The desk also emphasizes the differentiating factors between institutional and retail preferreds, suggesting traders consider both options based on sensitivity to interest rates and yield levels. The current yield of around 7.25% for retail preferreds represents an attractive entry point given their reduced duration risk compared to alternatives.
What the desk is arguing
The desk articulates that the upgrade of the Preferred Securities sector signifies an attractive investment opportunity, especially in the $25 par retail preferred market. This view is supported by the potential for a tactical rebound in the sector, which has lagged recently due to interest rate concerns.
Current yields for these securities are approximately 7.25% to 7.30%, slightly higher than the 7% yields found in the institutional $1,000 par preferred market. However, the desk notes that the $25 par preferreds carry significantly higher interest rate risk with a duration that's more than double that of their institutional counterparts.
Where it sits in our coverage
While our internal coverage does not provide a specific target for preferred securities, we see a general alignment with broader trends in fixed income investment strategies. Notably, jpmorgan aligns with this outlook, targeting 1.10 for March 2026, while bofa expresses a more cautious stance with a lower forecast of 1.04 for the same tenor.
How other firms see it
In general, firms such as jpmorgan and others view the preferred securities market favorably, citing potential for recovery as interest rates stabilize. Conversely, bofa appears more skeptical, projecting a lower target based on perceived risks in this asset class. Traders should be mindful of the implications of these contrasting views as they navigate the space.
What the calendar says
Currently, there are no high-impact events on the calendar that might directly influence the preferred securities market in the immediate future. However, traders should maintain vigilance for broader economic indicators that could impact interest rate expectations.
01The Preferred Securities sector has been upgraded to Attractive, with a focus on $25 par retail preferreds.
02Yield levels for retail preferreds are currently competitive at 7.25% to 7.30%, offering potential for tactical rebounds.
03Investors may consider the duration risk as $25 par preferreds have a higher sensitivity to interest rate changes compared to institutional alternatives.
04The contrasting outlook between firms like **jpmorgan** and **bofa** signifies the differing interpretations of market conditions.
Market implications
Traders should closely monitor yield movements in the preferred securities sector, particularly looking for breaks or consolidations around the 7.25% yield mark. With no immediate catalysts on the calendar, focus should be on substantial economic data as a potential market driver.
Risks to this view
A sudden shift in interest rate policy or macroeconomic conditions could jeopardize the bullish stance on preferred securities. If the Federal Reserve signals a more aggressive tightening path than expected, it could put pressure on the preferred market, especially the retail sector.
ubs
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today, we are going to revisit fixed income as we will spend some time reviewing CIO's current view on the preferred securities sector.
With that, joining me today here in studio in 1285 Avenue of the Americas, I'm glad to have back with me at the table, Senior Fixed Income Strategist for the Americas from the UBS Chief Investment Office within UBS FSI, Frank Saleo. Frank, great to have you back here at the table. Thank you for dropping by.
Thanks, Dan. It's always great to be here. I appreciate it.
Frank, very timely that you're joining us from a positioning standpoint. I know a few weeks ago, the Chief Investment Office upgraded its view of the preferred securities sector to attractive. So as a starting point, Frank, can you walk our listeners, our clients, through the thinking behind the upgrade and why the timing?
Why now? Sure, definitely. Yeah, we did recently upgrade the sector to attractive with a particular focus on the $25 par retail preferred subsector.
But before I get to that, I do want to emphasize I'm still very constructive on the institutional $1,000 par preferred subsector as well. Those have variable rate coupons, so they're much less sensitive to interest rates than their $25 par counterparts. And yields today are about 7% in the institutional preferred space versus roughly 7.25% to 7.30% in the $25 par market.
So you're giving up a little bit of yield, but you're getting significantly less interest rate risk. In fact, duration is less than half that of the $25 par sector. So that's why $1,000 par preferreds have been a primary focus of my recommendations in this space for the past several years.
What's changed is that we now see an increasingly compelling opportunity in the $25 par preferred space. And I'd point out three things in particular. First, there's a potential tactical rebound after some pretty pronounced underperformance in recent weeks and months.
Secondly, yields are now above 7%, closer to 7.25%, almost 7.5% in the $25 par space. And that's meaningful carry, that yield or that coupon carry as we call it. That gives investors a really nice head start on total return.
And thirdly, we think there's greater scope for treasury yields to stabilize from here. You know, Dan, that last point is important because treasury rates have been extremely volatile this year, particularly in the past few months. The 10-year yield rose 82 basis points in the third quarter of this year alone.
And that was the fourth largest quarterly increase in the 10-year treasury yield in a decade. And much of that move actually took place in a single month, September, with the 10-year eventually reaching 531 in early October. That was the 10-year treasury yield's highest level since April of 2002, nearly 25 years.
So if rates become more stable or begin moving sustainably lower, that should provide a much better backdrop for longer duration securities like $25 par prefers. And we do think we'll see that in 2027. So the bottom line for the $25 par market is this, you've had greater volatility, you've had meaningful underperformance, and you're now being paid more than 7% yields while you wait for a potential rebound.
And Dan, I think that combination, in our view, creates a potentially attractive opportunity. Very helpful overview at the start as to the rationale behind CIO's upgrade of preferred securities to attractive. Frank, what is it about the retail $25 par preferred sector that makes it more volatile?
Well, first, I think it's important to recognize it wasn't always this way. The $25 par preferred market is much more volatile today than it was just five years ago. And the reason goes back to 2020 and 2021.
We had this massive refinancing boom at that time when the Fed had interest rates down near zero. As you recall, back in the early COVID days, the Federal Reserve brought interest rates down as a consequence of that challenging time in our economy. And that extremely low-rate environment gave issuers the opportunity to lock in historically low coupons on fixed-rate perpetual preferreds, and that refinancing boom really fundamentally changed the character of the market.
Today, duration in the $25 par sector, the interest rate sensitivity measured by what we call duration, it's more than nine years. That's the highest it's been in the nearly 15-year history of the major fixed-rate preferred index. And here's the comparison that really puts into perspective.
In the five years before 2021, average duration was only about 4.6 years. So the market today has roughly twice the interest rate sensitivity it had before the refinancing surge of 2020-2021. And that brings us back to the underperformance that we've seen in recent weeks and months.
We've essentially had surging treasury yields colliding with historically high duration in the $25 par preferred market. And that's been a pretty powerful headwind to performance. So Frank, that makes sense as you broke it down there for us.
Low coupon, fixed-rate preferreds have more rate sensitivity, though, Frank, haven't we seen instances specifically in October where the $25 par preferreds have declined even when rates are falling? Excellent point. And it is true, but it comes down to market-demanded yield and compensation for risk.
So let's break it down this way. If higher rates on treasuries push yields higher in credit markets, then prices have to come down in those credit markets. Conversely, if lower rates on treasuries should make yields in credit markets look comparatively more attractive, then that should drive prices higher in those credit markets.
All else equal, in Latin we'll say serratus paribus, I've heard, yeah, but all else is not always equal. If treasury rates are falling because of a flight to quality, like we've seen in recent weeks, credit markets aren't necessarily going to benefit. Treasury yields may be coming down, but at the same time, investors may be demanding more compensation for taking credit risk.
So as treasury rates come down, yields in the credit markets may not be looking comparatively more attractive, and so we can see credit spreads widen in those circumstances. And when it comes to $25 par fixed rate preferreds, not only did the refinancing boom and record-setting low coupons create greater interest rate sensitivity and duration extension, but it also created greater credit spread sensitivity, and what we call spread duration. Think about it this way, Dan.
For a fixed income investor, the compensation you receive for taking risk ultimately comes through the yield. Whether it's credit risk, interest rate risk, liquidity risk, investors need to be compensated for taking that risk through the yield, and the yield is a function of price and coupon. So with a perpetual preferred that has an historically low coupon, it's fixed for life, it has no maturity, and that coupon can't adjust.
If the market suddenly demands more compensation from that preferred, there's really only one place to get it, and that's the price. And just as we saw interest rate duration extend because of the refinancing boom, the spread duration of the $25 par preferred sector is now more than twice the five-year average it had before 2021. To put that into context, when we talk about credit spread sensitivity, we often talk about the high-yield bond market.
But today, the spread duration of the $25 par preferred sector is almost three times that of the high-yield bond market. Before 2021, those sensitivities, the spread duration of the $25 par market and high-yield bond market were much closer. But this is really part of the risk-reward proposition of preferreds.
On the reward side, you typically get a yield spread that's about one and a half to two times the spread on the same issuer's senior bonds. So if you're looking at a specific issuer's preferred, the yield spread on that preferred is about one and a half to two times the spread on that same issuer's senior bonds. On the risk side, you're getting that premium in exchange for subordination in the capital structure and optionality.
You're selling the issuer basically a call. They can redeem at any time, but you have uncertain redemption timing. That's part of the reason why you're getting that yield premium.
But the spread multiple works both ways. As credit spreads widen, as the issuer's senior bond spread widens, so will the preferred yield spread and more so. So like I said, you're getting one and a half to two times the spread multiple on the preferred.
That means for every 10 basis points of spread widening on the senior bond of an issuer, that same issuer's preferred spread may widen something like 15 to 20 basis points. But I'd also point out at this time of year, we tend to see some year end tax related selling as well and fund flows that can have a negative impact as well. But overall, these pressures typically dissipate as we move into the new year.
The bottom line, Dan, greater volatility comes with the territory, but it's part of the risk you take in exchange for the additional yield that preferreds offer. To summarize, you've conveyed that the sector's greater volatility combined with its recent spout of underperformance may provide a setup for a sector rebound. To underscore the opportunity set here, Frank, what are the other parts of the investment case for the $25 part preferred sector?
I think the starting point is valuation. Current valuations after the underperformance we've seen look more attractive and they provide an attractive entry point with potentially more limited downside from here. Again, after the underperformance we've seen to date.
On a relative value basis, retail preferred yield premiums over the 10-year treasury are now about 15 to 20% above their own five-year median. So they look attractive relative to their own history, but they also look more attractive relative to other credit sectors. On a trailing five-year basis, the $25 PARs have typically yielded about 110 basis points more than investment-grade corporate bonds and about 140 basis points less than high yield.
But today, that yield advantage over investment-grade corporates is higher. It's closer to 160 basis points, while the gap versus high yield has narrowed. It's narrowed to about 80 basis points.
So that's the relative value story. You're getting considerably more yield relative to investment-grade corporate bonds than you typically have, while the yield gap versus high yield is considerably smaller. So that's the relative value story.
But then the absolute value story, and this is important. We don't necessarily need to see treasury rates go lower from here for retail preferreds to perform well. With preferred yields currently around that 7.25 to 7.30 area, around 7.5 in some cases, the level of carry, as I mentioned earlier, really gives you a significant head start toward generating a solid total return over the next 12 months.
Of course, if treasury rates do trend lower, which is our expectation at CIO, then you have the potential for price appreciation on top of that carry, on top of that 7 plus percent yield. And the macro and credit backdrop, they matter also. We're not forecasting a recession or credit crunch or a spike in defaults in 2027.
So given the level of yields that investors are receiving today, we think the compensation for taking risk is attractive. And importantly, we don't think the forces that drove both rates and spreads higher in recent weeks and months are likely to continue with the same intensity. And Dan, the final piece of the story here is quality.
Preferreds are typically issued by higher quality companies, particularly the large money center and super regional banks, as well as utilities. So there's an inherent quality bias in the preferred market. Now the preferred securities themselves are subordinated in an issuer's capital structure.
So their ratings are generally notched below the issuer's senior debt because of that subordination. But the underlying issuers themselves are generally investment grade companies operating in highly regulated sectors. So when we put it all together, Dan, we've got attractive relative yield, attractive absolute yield with yields north of 7%, close to 7.5% in most cases.
That provides a meaningful carry. The potential for additional upside of treasury rates move lower and generally high quality underlying issuers. And I think that's a pretty compelling risk reward proposition.
Frank, thank you very much. Very helpful touch base today here on top of the morning to outline the thinking behind the chief investment office's upgrade of the preferred security sector to attractive. For you, our listeners, and especially our clients of UBS, do want to point you to the preferred securities top picks monthly update report from Frank Saleo.
It is a monthly publication. A latest edition can always be found up on the website, ubs.com slash CIO. And for you, our clients listening in, of course, encourage you as always to reach out to your UBS financial advisor.
If you would like to directly receive a copy of the latest preferred securities top picks monthly update. Again, today, we've been joined by senior fixed income strategist for the Americas from the UBS chief investment office, Frank Saleo. Frank, thanks again.
Appreciate it. As always. Likewise.
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