Interest rates on investment-grade corporate debt are at historic lows, but we see value in preferred shares for fixed income portfolios.
U.S. fixed income markets had another milestone week as the average yield on investment-grade corporate bonds slipped below two percent for the first time on record, while the average price of a bond in the ICE BofA US Corporate Index has swelled to an also-record $1,150, a hefty premium to par values of $1,000. Bond yields and prices move inversely.
A number of factors drove the plunge, with the Fed’s ongoing corporate bond purchase program receiving much of the credit—or perhaps the blame, depending on one’s point of view—but to date the Fed has purchased just $43 billion of corporate bonds, a fraction of the $750 billion authorized size of the program. While the Fed’s backstop for the corporate bond market is a factor, it’s not the full story, in our view.
Treasury yields are back on the move lower as well, with the 10-year Treasury yield back below 0.60 percent for one of the first times since the market volatility of March and April, having ascended as high as 0.90 percent in June. At the same time, credit spreads—or the yield premium over Treasuries for credit risks—have faded to just 1.29 percent, also the lowest since March and largely due to the stock market rally that has reduced risk premiums and corporate credit concerns.
Additionally, personal savings rates for U.S. consumers have skyrocketed in recent months, reaching as high as 32 percent of disposable income in April, well above the 6.6 percent average since 1990, only adding to the problem of too much cash chasing too few “safe assets” despite all of the corporate and government debt issuance this year.
All told, it has been a perfect storm fueling the recent run lower in corporate bond yields. But with record low yields, companies are increasingly able to call away bonds from investors and refinance at ever-lower rates, a positive to corporate balance sheets, but a challenge for investors who then have to reinvest at lower rates or in outstanding bonds that carry increasingly high premiums to par values.
While rallies across many markets have raised valuation concerns, seemingly limiting investment opportunities, one sector we continue to see some value in is preferred shares, particularly those issued by financial institutions, and more specifically the hybrid preferreds that feature fixed-to-floating rate coupon structures.
As the chart shows, debt issued by financial firms is the largest constituent of investment-grade corporate bond indexes, and likely also accounts for a large proportion of the holdings in individual fixed income portfolios as well—meaning there may be opportunities to swap between bonds and preferred shares while staying within the Financials sector and, therefore, only incrementally increasing credit risk, but adding attractive yield to portfolios at a time when quality income is hard to find.
The average yield on an index of banking sector debt with an average maturity of about four years currently stands at just 1.0 percent, with an average price of approximately $1,060. Compare that to an index of banking sector preferred shares with a similar duration (or interest rate sensitivity) of four years and a dollar price of $1,070, but with an average yield of 4.4 percent. That yield advantage of about 3.4 percent is the greatest since early 2014. Preferred shares fall lower in the capital structure, between senior unsecured bonds and common shares, but we think that yield pickup offers adequate compensation for slightly higher credit risk. Investors in traditional senior unsecured bonds would likely have to look to the speculative-grade corporate bond market to find similar yields.
While low interest rates and loan quality concerns will remain as challenges for the banks through the COVID-19 pandemic, we continue to see strength in bank balance sheets. As RBC Capital Markets, LLC Financials analyst Gerard Cassidy recently stated, “We continue to believe this crisis will be an earnings issue for the banks, rather than a balance sheet issue similar to 2008–09.”
All signs point to another period of lower-for-longer interest rates and yields. And while we always caution against “reaching for yield” outside of individual risk tolerances, an active approach to finding attractive risk-reward opportunities and yield can help to manage fixed income portfolios through this period.
Source - RBC Wealth Management, Bloomberg, ICE BofA US Corporate Index; data through 7/22/20
Source - RBC Wealth Management, Bloomberg; U.S. corporate debt weighted by GICS sectors; data through 7/22/20
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