What's takeaway 1 on Top of the Morning?

Preferred securities are underperforming relative to other credit markets, which limits potential yield recovery.

What's takeaway 2 on Top of the Morning?

Relative value concerns will likely continue to press down expectations for returns.

What are the market implications for Top of the Morning?

Traders should remain aware of the compressed yield environment as any upward movement in credit spreads could signal potential recovery. Additionally, keep an eye on relative performance across preferreds versus other risk assets to gauge overall market sentiment.

What are the risks to this view on Top of the Morning?

A reversal in current yields could result from a significant tightening of credit spreads, driven by macroeconomic conditions or a hawkish shift from central banks. Should there be a deterioration in credit quality or increased volatility in broader markets, it may also adversely affect the performance of preferred securities.

Top of the Morning: Preferred yields not wilting in the market heat

What the desk is arguing

The desk posits that the preferred securities market will see subdued performance due to a lack of relative value, which has historically acted as a tailwind for the segment. Per the full note source, Sileo outlines that the expected returns for preferreds, initially projected at low to mid-single digits for 2025, reflect ongoing struggles in the credit sector as spreads remain compressed, suggesting there are limited opportunities for recovery.

Despite low return expectations, the current environment has yielded returns that trail other credit markets. Sileo notes that as of early 2025, preferreds have underperformed relative to investment-grade corporate bonds, which were noted to be at multi-year low spreads. This weak relative performance underscores the challenges facing the preferred sector amid broader credit market dynamics.

Where it sits in our coverage

Given the current perspective on preferred yields, the aligned target for jpmorgan sits at 1.10, while bofa projects a more conservative target of 1.04. These targets highlight a spread that indicates diverging views on the trajectory of preferred yields through 2026.

The desk’s outlook aligns with the projections from jpmorgan, which favors a more optimistic return expectation, whereas bofa positions itself at the lower end of the spectrum, indicating a cautious stance. Thus, we can conclude the desk's call leans towards a moderate upside potential.

How other firms see it

Firms like jpmorgan are optimistic about preferred yields, suggesting a better recovery outlook, while bofa reflects skepticism surrounding the sector's current yields and risks. This clear delineation between the firms creates a landscape where traders might capitalize on mispriced expectations.

Closely monitoring USD/JPY could provide insights into how broader risk sentiment and credit conditions evolve, especially given the focus on yield premiums and spread compression within the credit space. Observing the performance of these currency pairs can highlight shifts resulting from changes in U.S. monetary policy or investor sentiment.

Hi, everyone. Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel.

Joining me right here today in studio, glad to welcome back Senior Fixed Income Strategist for the Americas with the UBS Chief Investment Office, Frank Sileo. Frank, thank you for dropping by. Great to be with you here at the table as always.

Likewise. Great to be here, Dan. I appreciate it.

So, Frank, I know you're joining us today because you recently authored a blog entitled Preferreds Yields Are Not Wilting in the Market Heat. So, tell us a bit about that. Yeah.

So, that latest blog post touches on one of the three major themes that I've been highlighting all year this year with respect to the preferred market. And that theme that that particular blog post references is the theme of relative value. At the start of the year, we had just modest return expectations for preferreds, something along the lines of maybe low to mid single digit returns for full year 2025.

And the main reason for those more muted expectations was basically relative value. At the start of the year, preferred yield premiums were at the lower end of the historical range. And, you know, the feeling at that time was that that would likely provide a headwind to stronger performance or at least the lack of a tailwind for stronger performance.

So, hence, expectations for modest returns low to mid single digits. And the fact is, however, investors have been struggling with relative value challenges across most credit sectors. If we look at credit spreads, both in the investment grade corporate bond and high yield bond markets at the beginning of 2025, those those credit spreads were near multi-year lows.

Yet, as we look at relative performance since the start of the year, relative performance in the first half of 2025, we see that preferreds have lagged most other credit markets. So while the preferred sector is on track for the subdued or lackluster returns that I had forecasted and expect for the second half of the year, for 2025, the comparisons, yield comparisons for preferreds have actually improved. So, you know, it's a little bit of that concept of prices and yields moving in inversely.

So the title of this latest blog post, Preferred Yields Are Not Wilting in the Market Heat, is actually a reference not only to the temperatures that are impacting most parts of the country here in the summer months and recent weeks, but also the hot credit markets that are making headlines in the financial press. And it's a counterpoint to the stronger performance of those sectors and the fact that those sectors that are outperforming preferreds potentially now have lower yields and therefore that gives better comparative yields for preferreds. So pulling it all together, what does this mean for investors compared to other sectors while valuation is not necessarily compelling in the preferred sector?

Not necessarily something to write home about, so to speak, but current valuations may represent a better entry point relative to those other spread product, those other credit sectors of the market right now. Well, it's a clever title, Frank, so appreciate the context behind that. It is worth mentioning that relative value is one of the three major themes you've been highlighting this year for the preferred sector.

So what are the other two? This sort of begs the question. Right.

So the second major theme, and I've actually been talking about this quite a lot, is the importance of sub-sector diversification. So when we think about the preferred market, it could really be subdivided into two sub-categories based on par value. We have $25 par preferreds, sometimes called retail preferreds, and $1,000 par preferreds, sometimes referred to as institutional preferreds.

And year-to-date, the preferred sector overall has returned about 3%. So again, we are on track for those subdued performance that I anticipated at the start of the year of returns in the low to mid-single-digit range. But as we look below the surface at the sub-sector year-to-date returns, we find that $25 par preferreds have returned 1% year-to-date, a 1% gain from the $25 par preferreds, but a 4.5% gain from the $1,000 par preferreds.

At the end of May, that divergence was even greater with a 2.3% loss for $25 par preferreds and a 2.2% gain for $1,000 par preferreds. In June and July, $25 pars outperformed and the performance gap has narrowed a bit. But what this really demonstrates, Dan, the year-to-date performance and divergence between these two subcategories, what it really demonstrates is that $25 par performance can be more volatile.

And part of the reason for that is we find that $25 par preferreds tend to be more highly correlated to the S&P 500. So looking back, for example, when the S&P 500 was on the verge of a bear market in March and early April around the tariff time, that's when $25 par preferreds were underperforming. More recently, as the S&P 500 is making new highs seemingly every day, new record highs, $25 par preferreds are outperforming.

So we see this higher correlation to the S&P 500 when it comes to $25 par performance. In addition, $25 par preferreds tend to have fixed rate coupons, making them more interest rate sensitive, and they tend to be more sensitive to asset flow volatility, asset flows into and out of preferred ETFs, more sensitive to the volatility in those flows, leading to performance volatility in $25 par preferreds more than $1,000 par preferreds. So what does this mean for investors?

Preferred investors should really think about whether or not they have enough subsector diversification when looking at their preferred sector exposure. If you're getting preferred exposure through a single ETF only, you may have little to no $1,000 par exposure there, and that's a really important consideration. Adding $1,000 pars to the mix may improve overall risk-adjusted performance by reducing return correlations with other sectors like common stocks.

And although I mentioned before, Dan, sometimes $1,000 par preferreds are referred to as institutional preferreds, but they are very accessible, they're very available to individual investors and our private clients here at UBS for sure. So that covers two themes. We have one more, right, Frank?

Two down, one to go. Okay, that leaves us right with the third theme. The third theme pertains to the continued and ongoing evolution within the preferred sector.

It's always changing, it's always evolving, and over the past year and a half we've seen continued evolution, and I've been calling this the prefolution. I'm thinking of trademarking that, maybe putting it on a T-shirt or something. Now, prefolution, yes, so traditionally the issuer composition of the preferred security sector has predominantly consisted of banks, about two-thirds of the issuer composition of preferreds has been banks, two-thirds or more.

But last year, in 2024, utilities were actually net issuers of preferreds, raising $15 billion worth of net proceeds in the hybrid preferred market, while in the bank preferred space we actually saw net redemptions to the tune of $10 billion. So $15 billion of net proceeds from utilities, $10 billion net redemptions from banks. In the meantime, year-to-date, we've actually seen net issuance again from bank issuers, but we've had $3 billion of net bank preferred issuance, whereas in the utility space, $7 billion of issuance of utility hybrids.

Also, insurance companies have jumped into the mix as well. They've been very active this year with more than $2 billion worth of hybrid preferreds brought to market by major insurance companies. So what does this mean for investors?

Greater technical support. As more non-bank participants continue to enter the market with increased issuance of subordinated debt hybrid preferreds, the preferred sector will provide a more diversified opportunity set and a source of quality income for a broader investor base. And that, along with supportive rates, with the Fed moving into a position of more likely to be reducing rates, together this should all lead to good overall performance in the second half for preferreds.

And for long-term investors, preferreds can really provide quality income with relatively solid yields. So Dan, pulling this all together, in summary, my three themes of the year and what they mean for investors. Number one, relative value.

Preferreds may provide a good entry point here relative to other sectors. Secondly, sub-sector diversification. If you're focused only on retail $25 par preferreds, you might be missing out, may be able to improve overall risk-adjusted performance by adding $1,000 par preferreds to your preferred exposure.

And then finally, my favorite word, prefolution, coming to a T-shirt near you. The entry of more non-bank issuers of preferreds is providing a wider opportunity set for a broader investor base. When I'm on the boardwalk, I'll keep an eye out for that.

And of course, have to mention as well, Frank, your latest Top Picks report that came in on July 23rd, right? Exactly. I do publish a monthly piece called Preferred Top Picks.

The latest one, as you mentioned, published July 23rd. The title of that particular one was The Heat Is On, continuing the theme. And I would note, I also publish more frequently the Preferred Securities Valuation Report.

That's published on a more frequent basis, typically weekly. And that report is basically a list of about 300 preferreds, including a list of 100 specific preferred securities recommendations. And I do want to point out the Top Picks report, as well as Frank's blog, which he has of course been making reference to on today's podcast, A Preferred's Yields Are Not Wilting in the Market Heat, both available up on UBS.com forward slash CIO.

For clients of UBS, simply reach out to your UBS financial advisor if you would like to receive copies of these resources directly. Though again, today we've been joined by Senior Fixed Income Strategist for the Americas with the UBS Chief Investment Office, Frank Saleo. Frank, always a pleasure.

Great to do this in person. Likewise. Thanks a lot, Dan, and stay cool out there.

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