The Long and Short
Signs of fatigue from perpetual preferred investors
| September 21, 2018
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The domestic preferred securities market has “matured” in the last few years as banks have generally filled that funding need as recommended by the Fed. The Collins Amendment in the Dodd-Frank legislation put an end to the use of hybrid securities in banks’ equity capital ratios. The phase-out of bank trust preferreds (TruPS) and other hybrids left a bit of a gap in the capital structure, which left perpetual preferred equity as the sole alternative. The Fed has recommended that banks target 1.5% of risk-weighted assets be funded with these perpetual preferred securities, though that is only a target and not a minimum requirement.
The credit cycle is now long-enough in the tooth that many of the preferred notes issued shortly after the financial crisis have been called due to the high coupons and high floating resets. We have discussed this economic decision and attractive short-term relative value in prior publications, but in short the notes with an “economic call” that remain outstanding should be valued with the expectation that the notes will be called in short-order, but that any price with a positive yield to call is a good price.
Demand for preferreds in the last 10 years has been very strong, which has pushed accepted yields down, and hence the floating reset levels, which in turn elevates the risk of extension when the notes are callable. The elevated risk of extension creates a less stable pricing dynamic for these kinds of securities, which has been evident each time there is a market scare or view of higher rates looming.
This week two perpetual callable preferred securities were issued that – almost as soon as they priced – traded below par, in large part because of the poor reset levels. Early in the week, GM issued a PerpNC10 at 6.50% with a reset of 3mL+ 343.6 bp, and now trades down 1.5 points. On Thursday, State Street issued a fully investment grade PerpNC5 at 5.625% with a reset of 3mL+253.9 bp and then traded back a half point on the break. This kind of pricing dynamic begs the question of “when will investors demand more for their risk?” We expect that if and when the time comes, it will bring more pricing downside to these low-reset notes.
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