Weekly Investment Commentary: A preferred take on the financials sector
Bottom line up top
- The good news: U.S. banks are strong. The old saying “there’s safety in numbers” takes on a new and different meaning if the “numbers” refer to the billions dollars U.S. banks have on hand to meet — and far exceed — regulatory capital requirements (Figure 1). This capital strength was on display again with June’s release of the Fed’s 2022 “stress test” results. A total of 33 institutions were subject to hypothetical crisis scenarios that included “a severe global recession accompanied by a period of heightened stress in commercial real estate and corporate debt markets,” per the Fed. The banks proved able to absorb more than $600 billion in losses while, on average, topping minimum common equity capital requirements by at least 2x for the duration of the test. Separately, banks have increased their loan loss reserves this year given economic uncertainty, but actual delinquency rates and credit trends have generally remained benign.
- But earnings for the financials sector are down sharply. Banks and other financial companies released 2Q results beginning in midJuly, but since they’re always among the first to report, it can take some time to meaningfully assess their earnings growth relative to other sectors and the S&P 500 Index as a whole. Now, with earnings season winding down, financials ended up the weakest performing sector in terms of 2Q year-over-year earnings growth (-25% for the sector and -28% for banks specifically, versus +4% for the overall index) and had the second-lowest percentage of earnings beats (63%) and revenue beats (56%). There were some bright spots, including higher net interest income and net interest margins.
- Preferred securities: a way to benefit from the underlying strength of the financials sector. Despite this year’s lower earnings environment, preferred securities — 75% or more of which are issued by banks and insurance companies — can be a compelling portfolio allocation. In addition to healthy credit fundamentals, preferreds offer generous yields, both absolute and after-tax, with their high income stream serving as a total return buffer against future spread volatility. These and other advantages may make the asset class especially attractive for investors with tax considerations, as we demonstrate below.
“The latest stress tests showed banks could absorb more than $600 billion in losses and still exceed capital requirements by 2x.”
For tax-sensitive income investors, preferreds can be a source of taxefficient income that diversifies municipal bond holdings and other investments. That’s because unlike bond coupons, many preferred securities pay distributions that are often taxed at the qualified dividend income (QDI) rate (23.8% for the highest earners), which is lower than the ordinary income rate (40.8%). Using the latest yield for the ICE BofA U.S. All Capital Securities Index of 5.69% and assuming 100% of income is QDI, this would imply a tax-equivalent yield (TEY) of 7.47% — attractive alongside tax-equivalent yields of 4.71% for investment grade municipals and 8.48% for high yield municipals (Figure 2).
Within preferreds, diversification across segments is key to obtaining more attractive risk/reward potential (Figure 3). For example, the $1,000 par market segment offers a spread over U.S. Treasuries of 296 basis points (vs. only 114 bps in the $25 par market) and has a duration of 3.5 years (vs. 6.8 years). With a yield-to-worst of 6.20% for $1,000 par preferreds, if market turmoil causes spreads to widen, a 100 bps move would result in just 0.56 years’ loss of income. This is relatively low compared to most plus sector areas of fixed income.
Putting it all together: Credit spreads well above historical averages for preferreds and other credit sectors create an attractive entry point for longerterm oriented fixed income investors, particularly those with an eye toward tax efficiency.
“Within preferreds, diversification across segments is key to obtaining more attractive risk/reward potential.”
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