18-Feb-2022
In the previous weekly we discussed how low-coupon preferreds have underperformed during the recent rise in interest rates due to their longer-duration profile. This week we talk about another key variable that investors ought to keep an eye on which is coupon structure, specifically, fixed-rate vs. fix/float coupons.
Fix/float preferreds are those that feature a change in their coupon from a fixed-rate to a floating-rate, such as Libor (a proxy for 3-Month bank unsecured rates) or CMT (Constant Maturity Treasury which is typically the 5Y Treasury yield, reset every 5 years).
The recent bear flattening of the yield curve where short-term rates have risen faster than longer-term rates remains a key theme in the income space, and particularly, for preferred stocks. Since the start of the year 2Y and 10Y Treasury yields have risen 0.77% and 0.40% respectively.
This fast rise in short-term rates has favored fix/float stocks over fixed-rate stocks as the following year-to-date performance trajectory of the Banks sector shows.
If we break down performance across one issuer to control for credit quality we get the same result. The J and K Goldman Sachs series are Libor fix/float while the other 3 series are fixed-rate (they are technically, floating-rate but have such as high fixed-rate floor and low spread over Libor that they are basically fixed-rate).
The key takeaway here is that not only do investors have to track the obvious stuff like credit quality, they also should keep an eye out for coupon level and coupon structure – two key drivers of interest rate sensitivity. Phrased another way, relative performance across the preferreds market is driven by both yield level (which drives differential performance across coupon levels) and well as the shape of the yield curve (which drives differential performance across coupon structure i.e. fixed vs fix/float series).
A final takeaway is to beware the old saw that “fix/float preferreds have a lower duration”. This may be correct when rates are rising but is precisely incorrect when rates are falling. This is because when short-term rates are falling, coupons of fix/float securities are more likely to reset to lower levels which will lengthen their duration exposure. And, perhaps, more intuitively, it makes these series unappealing as investors will tend to flock to securities that do not face a coupon step down on the first call date.
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