Indicators are signaling a potential decline in inflation next year and an end to the Federal Reserve’s rate hikes by May. Cohen & Steers argues in new research that preferred securities could offer strong total returns in that scenario.
Preferred securities are fixed income products with equity-like traits. Many preferreds pay investors qualified dividend income that is taxed at a lower rate than interest. They are typically issued by large financial institutions, utility companies, and real estate firms that don’t want to dilute their common equity shares.
In a report expected to be published on Monday, Cohen & Steers found that preferred securities often have strong performance after rate hikes, outstripping other types of fixed income products like investment-grade and high-yield bonds. Since 1990, they have achieved an average 12-month return of 12.7 percent after rate hikes, compared to 10.2 percent for investment-grade bonds and 9.9 percent for junk bonds, according to the report.
In addition, for the same time period, Cohen & Steers found that preferreds delivered double-digit returns in six out of seven years following a negative total return. “With preferreds down nearly 13 percent in 2022 through November 30, we anticipate an attractive rebound in 2023,” according to the report.
Cohen & Steers’ bullish outlook on the securities comes at a time when the overall fixed income market is due for a comeback after the Federal Reserve signaled a slowdown in aggressive rate hikes. “This year is the worst since the global financial crisis in terms of performance,” said Bill Scapell, head of fixed income and preferred securities. “And if you believe that central banks are going to win, meaning that they are going to break inflation and bond yields are going to come down, then next year is going to be a very good year for fixed income.”
Preferred securities have many advantages over investment-grade and distressed bonds in the current market. According to Scapell, the average yields that preferreds offer to investors are 2 percent higher than those offered by the rest of the corporate bond market. They are riskier than fixed income, as investors are paid out after bondholders when an issuer defaults. But because institutions issuing preferreds are in good financial shape now, their chances of defaults are low, according to the report.
“The banking system and the insurance system are both highly capitalized now,” Scapell said. “They’ve been well regulated. They don’t take anywhere near the types of risks they used to take prior to the GFC.”
Preferreds also have tax advantages, according to Cohen & Steers. The dividend income paid by preferred securities is taxed at 20 percent, significantly lower than the 37 percent tax for interest income earned by other types of fixed income products. In addition, preferreds offer diversification benefits because they have a low correlation with stock markets and other fixed income products, according to the report.
“[For] an income investor, [preferreds] are extremely attractive because the rates are high, the quality is good, and you have the tax advantages,” Scapell concluded. “Whenever I see preferreds offering yields in this context, at least by historical standards, they have always done very well.”
