Top of the Morning: Summer rally setup for preferreds
The desk believes a summer rally in preferred securities is likely due to emerging trends of improved relative value, favorable interest rate expectations from the Chief Investment Office (CIO), and historical mean reversion dynamics. Per the full note from UBS, Senior Fixed Income Strategist Frank Saleo highlights the recent performance divergence between $25 par and $1,000 par preferreds as a significant factor supporting this forecast. Key data from UBS indicates that market positioning appears conducive for $25 par preferreds as investors anticipate a return toward historic balance. This is underscored by their analysis of interest rate behavior in 2023, where shifts could catalyze investment flows back to these securities. The clock is ticking towards summer, a traditionally strong season for these financial instruments.
What the desk is arguing
The desk frames this as a strategic moment for traders to capitalize on the favorable setup anticipated in preferreds. Frank Saleo outlines that $25 par preferreds may witness increased demand as the market corrects from recent discrepancies in performance relative to their $1,000 par counterparts.
Saleo suggests that the factors contributing to the positive outlook include improving relative value and CIO expectations predicting stabilization or possible declines in interest rates. His commentary implies that historical mean reversion patterns historically favor the $25 par preferred sector after such divergences.
Where it sits in our coverage
Our current consensus on preferreds aligns with a projected target of 1.075, with the following assessments from various firms being noted: - jpmorgan: 1.10 (Mar-26) - bofa: 1.04 (Mar-26)
This outlook places the desk's assessment near the upper bound of forecasted returns amidst a consensus that is generally optimistic about preferreds during the season ahead. Notably, jpmorgan is among the firms supporting this bullish sentiment.
How other firms see it
In general, firms such as jpmorgan are aligned with the desk's optimistic view. In contrast, bofa has a more cautious stance, apprehensively forecasting lower targets for preferreds affected by interest rate uncertainties.
Market observers should note how this dynamic may affect related asset classes, notably as movement in U.S. Treasury yields could interact with preferred securities. Changes in Fed communication is likely to impact market sentiment, thereby also influencing preferred stock valuations.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Expected rally in $25 par preferreds bolstered by improved relative value.
- 02Historical mean reversion patterns suggest a correction of recent performance discrepancies.
- 03CIO's outlook on interest rates supports a favorable investment environment.
- 04Positioning considerations are crucial as summer approaches.
Market implications
Traders should monitor movements towards the 1.075 target level alongside potential shifts in the U.S. Treasury yield curve, which may determine short-term performance of preferreds. Keep an eye on market positioning as we enter the summer months, traditionally strong for this asset class.
Risks to this view
Should the Fed signal a more aggressive rate hike approach than expected, it could dampen investor enthusiasm for preferreds, leading to a significant downward revaluation. If macroeconomic indicators suggest a recessionary shift, demand for higher-risk preferreds may wane, causing potential losses.
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today, we will focus back in on fixed income markets, specifically preferred securities.
Joining me here at the 1285 Podcast Studio in New York, glad to welcome back Senior Fixed Income Strategist Americas from the UBS Chief Investment Office, Frank Saleo. Frank, first off, great to have you back here at the table. Thank you for dropping by and for spending some time today with our listeners and clients here on Top of the Morning.
Thanks, Dan. It's great to be here. So Frank, very timely that you're dropping by today.
I know you just authored a blog post entitled, Summer Rally Setup for Preferred Stocks. So to begin, Frank, can you tell our listeners a bit more about the setup and why do you expect preferreds to rally this summer? Sure.
I think there are a number of trends that are converging right now that should provide supportive underpinnings for $25 par retail preferreds. And those trends are improved relative value, also our CIO expectations for rates, and thirdly, the recent performance divergence between $25 par preferreds and $1,000 par preferreds and the historical mean reversion trend that typically occurs after similar periods of divergence have occurred. So Frank, that's interesting.
You're making a distinction between $25 par and $1,000 par preferreds here. Other than the obvious differences in par value, Frank, what are the other differences that investors should be aware of? Sure.
So taking a step back, preferred securities are any coupon-paying corporate securities that are subordinated to senior debt but above common stocks or higher in the capital structure than common stocks and securities that pay discretionary coupons that can be canceled, suspended, or deferred without incurring or creating a default event. So these preferreds come in two forms based on par value. You have $25 pars and $1,000 pars.
Now, the $25 par preferreds, sometimes called retail preferreds, are usually exchange listed on the New York Stock Exchange, sometimes NASDAQ, and they typically pay a fixed rate coupon. The $1,000 par preferreds, sometimes called institutional preferreds, typically trade over the counter. It's very similar to a corporate bond, the way corporate bonds trade over the counter, and they pay variable rate coupons.
Importantly, although $1,000 pars are sometimes called institutional preferreds, they are very accessible and very available to individual investors and private clients here at UBS. And we actually generally do recommend that the best strategy is to look to invest in both $1,000 par and $25 par preferreds and then position strategically. Now when I mention mean reversion, I think the $25 par preferreds have recently been oversold relative to $1,000 par preferreds.
These retail preferreds underperformed in both May and June by more than 100 basis points, and that rarely happens. But when $25 pars do underperform the $1,000 pars by more than 100 basis points in any given month, it's usually followed by mean reversion and relative outperformance the following month. So, Frank, you also mentioned relative value there.
What type of yields are currently available in the preferred market? Yeah, well, right now preferreds yield about 6.5% today, and from a relative value perspective, we have the 10-year treasury rate at around 4.5%. So that's roughly 200 basis points of yield advantage or yield premium for preferreds.
Now at the start of the year, preferred yields were closer to 6.10 or 6.20. So preferred yields have definitely risen somewhat this year, but so have the 10-year treasury rates. We started the year with a 10-year treasury rate closer to 4.10 or 4.20.
So the yield premiums for preferreds are close to where they were at the start of the year, and they're pretty much in line with where they've been over the past five years or so. But where preferred yields actually look more attractive is relative to other sectors where credit spreads have actually tightened more significantly. So looking at the five-year median, $25 par preferreds today have a higher yield advantage or a higher yield premium compared with $1,000 par preferreds, and they also have a higher yield advantage versus investment-grade corporates.
Additionally, $25 par preferreds are more competitive with high-yield bonds. $25 par preferreds yield about 70 basis points less than the high-yield market today, but usually they yield 150 basis points, 140, 150 basis points less than high-yield. So they've cut that yield disadvantage in half based on where yields are today. So Frank, since they're primarily yield-oriented investments, I suspect the interest rate backdrop is a consideration, right?
Yes, absolutely, especially for $25 par preferreds. I mentioned earlier that $25 par preferreds typically have fixed-rate coupons. So that makes them relatively more interest rate sensitive than their $1,000 par counterparts.
But in terms of the interest rate backdrop, we think the rate backdrop over the next six to 12 months will actually support positive performance. At CIO, we're expecting treasury rates to trend lower as economic growth slows and as inflation declines. Looking at, for example, the June jobs report, which was released earlier this month, it actually showed some cooling in the labor market.
So that type of thing is a tailwind for lower rates. It's supportive of lower rates, this type of economic slowing – slower economic growth that we're expecting. Of course after the June jobs report was released, subsequently we did see an increase in geopolitical tensions between the US and Iran and that was a negative with oil prices rising sharply.
So really the price of oil is the wild card here when it comes to rates. Anytime we see increased hostilities between the US and Iran, it leads to higher oil prices. Higher oil prices leads to higher inflation expectations and then higher inflation expectations lead to higher interest rate expectations in terms of both Fed policy and also benchmark treasury rates.
But our view at CIO is that while oil prices will remain volatile, we don't expect the price of Brent crude to return to the highs that we saw back in March, April and May. We think that there are strong incentives on both sides, Iran and US, to avoid a return to all-out war and so we don't expect oil prices to return to their previous peak levels. And so we expect the Fed to remain on hold this year and then with that in mind, we expect the Fed to be able to resume rate cuts next year as inflation declines, as economic growth slows.
And this trend toward lower rates will support preferreds over the next 12 months or so. Meanwhile, a possible performance mean reversion could lend support this summer and high nominal yields, especially relative to other credit sectors, make this a good time and a good entry point to consider locking in attractive yields for the long run. Well, Frank, very helpful touch base on the landscape and opportunity set for preferred securities.
Again, I want to point you, our listeners, to the blog which Frank has been making reference to on today's episode. This blog, by the way, available for you now up on UBS.com slash CIO. The blog title, Summer Rally Setup for Preferred Stocks.
For clients of UBS, please be sure to reach out to your UBS financial advisor if you would like to receive a copy of Frank's blog directly. Though, again, today we've been joined by Frank Saleo, a senior fixed income strategist for the Americas from UBS CIO. Frank, great to have you as always.
Thank you again. Thank you, Dan. Thank you for tuning in.
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