Preferred Securities

5 Questions for Preferreds in the Pandemic William Scapell, CFA, Head of Fixed Income and Preferred Securities and Senior Portfolio ManagerElaine Zaharis-Nikas, CFA, Senior Vice President and Portfolio Manager Jerry Dorost, CFA, Senior Vice President and Portfolio Manager

As investors continue to gauge the impact of COVID-19, we offer our thoughts on key issues affecting the global preferred securities market, including the health of U.S. and European banks, insurance company exposures, default risk and high yield market comparisons.

Inside:

1. Are U.S. banks healthy enough to weather the storm and continue paying preferred dividends?

2. What is the risk that European banks hit capital triggers or CoCos stop paying dividends?

3. How exposed are insurance companies to potential losses and COVID-related claims?

4. What are the potential default risks based on historical rates (especially during the global financial crisis)?

5. How does the high yield market compare to the preferred securities market right now?

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5 Questions for Preferreds in the Pandemic

1. Are U.S. banks healthy enough to weather the storm and continue paying preferred dividends?

Strong balance sheets, ample liquidity, unprecedented policy support and still-adequate profitability should enable the banks in which we invest to continue paying preferred dividends.

Unlike in 2008, U.S. banks are entering this stress period from a position of strength. Due to stricter post-crisis regulations, average risk-weighted core capital ratios are now well over 10%, compared to ~6% in early 2008. This comparison understates the actual improvement, as the calculation basis has become harsher, including higher effective risk weights on similar assets and elements deducted from capital. Furthermore, changes in banks’ business models have made them far less susceptible to fluctuations in capital markets, in our view. Funding is also strong, with banks required to hold large amounts of high-quality liquid assets to cover funding needs.

For these reasons, we believe banks’ positions are now much more sound. However, regulatory minimum requirements are also substantially higher, and banks must maintain high ratios in order to continue to pay “discretionary items,” including common dividends, preferred dividends and employee bonuses.

Importantly, the Federal Reserve, with the backing of the U.S. Treasury, has been aggressively utilizing its tool chest to support credit markets. The Fed’s experience during the global financial crisis provided a ready playbook, allowing them to move quickly and forcefully, and some programs go well beyond what was offered before. Since cutting interest rates to zero in March, the Fed has ramped up quantitative easing (QE), buying record monthly volumes of Treasury and agency mortgage-backed securities. Additionally, for the first time ever, it will buy corporate bonds and commercial paper, including new issues of investment-grade companies. It may also buy exchange-traded funds (ETFs) that own high yield obligations, and it will provide support to certain structured product markets.

Similarly, the many programs enacted by Congress—including substantial additional benefits for unemployed workers and a very material loan (and forgiveness) program for small businesses—may ameliorate economic distress.

We believe these actions should reduce economic downside and help to mitigate nonperforming loan formation.

Rather than being part of the problem, as they were in 2008, banks are now an integral part of the solution, helping regulators and governments deliver money into the system to help keep businesses afloat.

Despite efforts by the Federal Reserve and the U.S. government, we expect economic conditions to be very challenging in the near term, with recessionary conditions lasting over the next two quarters before a mild but sustained rebound as people go back to work. Banks will face an increase in nonperforming loans over time, as well as some pressure on capital due to higher client demand for loans, including drawdowns on lines of credit.

Overall, we expect substantial near-term pressure on banks’ earnings as they provision against rising expected losses and potentially face somewhat lower net interest margins due to the Fed’s rate cuts. Still, banks have been conservative in their lending standards, keeping the rate of nonperforming loans relatively low (just 0.5% in 2019). An extreme jump to 3%—similar to the peak of the 2008 crisis—might cut earnings by 80–90%. An earnings decline of that magnitude, together with some asset growth to support the economy, could pressure capital ratios and limit the ability to pay common dividends—but we would still expect banks to continue paying preferred dividends.

Due to the size and swiftness of the government response to the crisis, we believe such a scenario is unlikely. We expect average cumulative earnings declines for the large U.S. banks to be more likely in the 40–50% range over the balance of the year as banks front-load reserve building ahead of future losses. Some consumer-oriented finance companies could face larger earnings declines, depending of the severity of the recession.

We expect large U.S. banks to remain profitable on an annual basis through the crisis, even in our bear-case scenario, which utilizes Fed stress test information. For our base case, we believe the banks will have room to continue to pay common dividends—though these may come down—while remaining above capital levels necessary to make such payments.

A caveat to our base and bear cases relates to whether the spread of COVID-19 infections can be stemmed in the near term and kept at bay when people begin to gather again. We assume the economy will begin to normalize in the third quarter. We also recognize that some industries, such as hospitality and large-venue entertainment, might suffer much more prolonged demand declines, leading to more permanent impairments. And clearly some businesses will fail despite government efforts.

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For the European banks in our portfolios, we estimate capital would need to decline by 30% on average before preferred dividends would be at risk.

With uncertainties ahead, bank equity investors will rightly question the path of common dividends, which could pressure bank stocks. However, we believe the combination of strong capital levels and asset quality to start, and our expectation for continued, albeit weak, profitability even in a very stressed scenario, suggests that the U.S. banks in which we invest should be able to maintain dividends on their preferreds.

2. What is the risk that European banks hit capital triggers or CoCos stop paying dividends?

While a growing risk for certain weaker names, we do not expect preferred dividend interruptions from European banks, as fiscal relief, high capital levels and looser regulatory requirements are providing a meaningful capital cushion.

European bank contingent capital securities (CoCos) fell more than the broader preferred securities market in the first quarter. A weaker economy to start, a higher dependence on manufacturing and small businesses, and a dire outlook for tourism mean European economies could fare even worse than the United States. European bank profitability was also weaker going into the crisis, though, as in the U.S., balance sheets were very strong and asset quality generally quite good.

Our European bank risk reviews have been based on expectations for a relatively severe recession in Europe, followed by a modest recovery in late 2020 and early 2021. In this scenario, we expect profitability among large banks to fall by more than 50%, but for banking system earnings to remain modestly positive on an annual basis. As in the U.S., we expect quickly ramping loan provisioning and greater demands on bank capital from customer needs. But we also note that the European banking system has far less unsecured consumer debt than that of the U.S.

Furthermore, we expect European economies to be aided by substantial fiscal stimulus and central bank accommodation, including QE programs. Germany, France and the U.K.—the region’s largest economies—have announced fiscal support measures of 15–20% of GDP. Also, the European Central Bank’s (ECB) €750 billion Pandemic Emergency Purchase Program (PEPP) goes beyond previous QE regimes, allowing far greater flexibility in its purchases. On net, this should keep funding costs low even in periphery countries such as Italy and Spain, which have been among the hardest hit by the outbreak.

As in the U.S., European investors have begun to weigh the risks of non-payment of bank preferreds. This concern grew after the ECB and Bank of England recommendations in late March that banks halt common equity dividends for the first three quarters of 2020 and discontinue share buybacks until the end of 2020. Notably, these recommendations were intended to preserve capital so banks can continue to provide credit. On a positive note, these suspensions could help reduce near-term capital depletion via higher earnings retention.

ECB regulators currently do not expect to ask banks to halt preferred dividends, as confirmed by the head of the ECB’s supervisory arm, Andrea Enria, who said the banks are “very far” from that threshold. He referred to a capital calculation used to determine whether discretionary items, including common and preferred dividends, as well as employee bonuses, can be paid. As with U.S. banks, regulators may require European banks to stop paying these items if the capital of an issuing bank falls below its minimum requirement.

In Europe, regulators have provided more room relative to capital requirements by effectively lowering minimums. Since the 2008 crisis, regulators have required banks to hold special capital buffers to prepare for a potential downturn, with expectations that requirements could loosen during a recession. Having recently reduced some of these buffers, the segment’s already solid capital positions have further improved, with our European bank holdings now showing an average 30% capital cushion relative to the minimum required for continued payment of all discretionary items.

Regulators have announced other accommodative measures as well, including greater flexibility for booking loan loss provisions for creditors temporarily affected by the virus, likely mitigating negative near- to mid-term impact on profitability and slowing implementation of mark-to-market accounting for certain assets.

As in the U.S., we view most European bank preferred/CoCo payments as able to continue. However, we note that while our estimates assume a harsh downdraft and a relatively tepid economic recovery, they also envision COVID-19 issues being well contained by the fourth quarter. Clearly, there is a risk to that assumption.

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5 Questions for Preferreds in the Pandemic

3. How exposed are insurance companies to potential losses and COVID-related claims?

We see little exposure for most property and casualty (P&C) and reinsurance companies, as most policies written since 2006 have exclusions around pandemics and any non-named diseases; recent efforts by certain states and federal lawmakers to retroactively define such policy exclusions face a high hurdle, in our view.

We believe the two primary risks to consider for insurance company issuers are investment portfolio returns and claim liability risk.

Both life and P&C insurers may face pressure in their investment portfolios from market volatility and lower interest rates. Life insurers usually rely more on these returns due to their lower underwriting margins. However, most have right-sized portfolio risk exposures compared to pre-2008, and capital is strong. Reinsurers are less at risk from investments, in our view, as their investment portfolios tend to be more defensive compared with life and P&C insurers.

As far as liability risk, we see little exposure for most P&C and reinsurance companies to claims around business interruption coverage. Most policies written since 2006 (following the SARS epidemic) have exclusions around pandemics and any disease not named. A few states and, recently, some members of Congress have attempted to introduce legislation that retroactively redefines these types of policy exclusions. However, we believe such measures would set a dangerous precedent that could destabilize the industry, and they seem highly unlikely to pass or withstand legal challenges. Perhaps the industry will come to some sort of agreement with lawmakers. For life insurers, overall mortality risk continues to appear manageable, though this could obviously change if virus data changes.

The above notwithstanding, we recognize that some business interruption policies still exist that do not specifically carve out pandemics and non-named diseases. Various estimates indicate that 20–40% of contracts do not have these exclusions. In these cases, risks may be somewhat higher. However, the policies generally require physical damage to property to pay out. There is a risk that lawyers could argue that the virus is a form of physical damage, but we believe this would result in a protracted legal battle. For now, we believe risk management in certain names with large books of small- and mid-size commercial property lines could make sense, but we do not expect this to be a significant risk for most companies.

4. What are the potential default risks based on historical rates (especially during the global financial crisis)?

Though we recognize that history may not be a perfect guide, preferred dividend impairments have nevertheless been significantly lower than for high yield, and we believe investors are being generally well compensated for this risk.

Even though the current crisis is unprecedented in many ways, past periods of extreme market turmoil may offer insights into relative default exposure. A study of dividend impairments, including default events and dividend omissions, for non-trust preferred securities and high yield bonds from 1983 to 2012 showed that the risk to dividends has been significantly lower for preferred securities (Ex. 1).

Average annual payment impairments across the entire 30-year period were 2.1% for the preferred securities market versus a more-than-double 4.6% in the high yield bond segment. Unsurprisingly, both asset classes experienced increased defaults during periods of volatility, but these spikes tended to be notably more pronounced in the high yield market. For instance, in 2009, preferred securities impairments were just 3%, compared with 12.1% for high yield.

This offers historical context for the two markets. For preferreds, dividend impairments have been generally manageable. However, it is important to note that regulators did not stop preferred payments for most issuers during the financial crisis, in part because they wanted to maintain confidence in the banking system. Regulations and politics have since changed, and there may be less inclination to protect payments today. However, as discussed above, fundamentals go much further toward protecting holders today. Moreover, banks today are part of the solution, not the problem.

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5. How does the high yield market compare to the preferred securities market right now?

The high yield market has a very different opportunity set. By comparison, preferred issuers typically are larger, have lower leverage, are less cyclical and are rated investment grade. The Fed’s bond purchases will include investment-grade debt (which characterizes most preferred issuers), whereas most lower-rated retailers, hotels, energy companies and other high yield industries are unlikely to receive government support.

The preferred securities and high yield markets are two very different universes. The distinction becomes even more apparent in this stressed environment, where it currently looks like overall pressures in the high yield market could be more significant, due to the more cyclical and highly leveraged industries represented in high yield—including energy and basic industries, lodging, retail and others—as well as the much greater government support now being allocated to investment-grade issuers.

For the first time, the Fed is buying U.S. corporate debt as part of its QE and credit support program. Purchases will be largely focused on investment-grade debt and will include both primary and secondary market purchases, as well as commercial paper. We believe these issuers are very unlikely to face a liquidity crunch while the program remains in effect.

Notably, “fallen angel” issuers—those with investment-grade ratings as of March 22nd that were subsequently downgraded due to the economic shutdown—will be included in the investment-grade buying program. While meaningful to market psychology, the Fed’s program for the high yield market appears to offer far less fundamental support. It is expected to consider allocating some capital (unclear how much) to purchases of ETFs that invest in the high yield market.

Though roughly one-third of preferred securities are rated below investment grade, the issuers themselves are almost all investment grade at the senior debt level and could therefore benefit from Fed (or other central bank) support. Targeted rescue actions, such as for airlines, could support select segments of high yield. However, other troubled segments—such as retailers, oil and gas exploration & production, and lodging companies—may receive far less backing.

EXHIBIT 1: Lower Dividend Impairment Risk vs. High YieldRate of Dividend Omission or Default Event

At December 31, 2012. Source: Moody’s, Cohen & Steers

Data quoted represents past performance, which is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated above will be repeated in the future or any way to know in advance when such a trend may begin. Based on Moody’s Default and Recovery Rates Study for the respective asset classes. The preferred securities analysis focuses on corporate preferred stock issues, excluding leveraged income and other funds that issue preferred stock, preferred stock issued as part of a structured finance vehicle, junior subordinated debt that might be considered a hybrid security, and trust securities (which have been largely phased out since the 2008 global financial crisis). A non-trust issuer is one which issues the preferred stock itself directly to investors. Most issuers were domiciled in North America and Europe. See back page for index definitions and additional disclosures.

0%

2%

4%

6%

8%

10%

12%

14%

Average: 2.1%

Average: 4.6%

High Yield BondsPreferred Securities

1983 1988 1993 1998 2003 2008

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5 Questions for Preferreds in the Pandemic

Conclusion

We believe a great deal of negative information has been priced into the preferred market. We think this makes sense, as we expect a very difficult economic environment in the near term, followed by a shallow recovery late this year and into 2021. Recognizing that some vulnerabilities remain, we believe that issuer fundamentals are mainly sound. In this context, we are finding some very attractive valuations, with many preferred securities paying tax-advantaged yields well above income rates offered on other quality assets (Ex. 2). In particular, preferred yield spreads to Treasuries are at historically wide levels, currently offering a 4.6% yield premium, compared with a long-term average of 3.3% since 1997.

EXHIBIT 2: Investment-Grade Fixed Income YieldsYield to Maturity (%)

0

2

4

6

Preferred Securities Corporate Bonds Municipal Bonds 10-Year Treasury

5.2

3.0 3.0

0.6

At April 22, 2020. Source: Bank of America, Cohen & Steers.

Data quoted represents past performance, which is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated above will be repeated in the future or any way to know in advance when such a trend may begin. An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses and taxes. Index comparisons have limitations as volatility and other characteristics may differ from a particular investment. See back page for index definitions and additional disclosures.

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William Scapell, CFA, Executive Vice President, is Head of Fixed Income and Preferred Securities and a senior portfolio manager for the firm’s preferred securities portfolios, with 27 years of investment experience. Prior to joining the firm in 2003, Bill worked in the fixed income research department at Merrill Lynch, where he was their chief strategist for preferred securities for three years and a vice president in the corporate finance and treasury department for two years. Previously, he served at the Federal Reserve Bank of New York for five years in bank supervision and monetary policy roles. Based in New York, Bill holds a BA from Vassar College and an MA from Columbia University’s School of International and Public Affairs.

Jerry Dorost, CFA, Senior Vice President, is a portfolio manager for fixed income and preferred securities portfolios, with 16 years of investment experience. He has analyst coverage responsibilities for banks, utilities and midstream energy. Prior to joining the firm in 2010, Jerry was with Citigroup, where his coverage included banks, mortgage lenders and other financial companies. He has a BS from Columbia University and is based in New York.

Elaine Zaharis-Nikas, CFA, Senior Vice President, is a portfolio manager for fixed income and preferred securities portfolios, with 22 years of investment experience. She has analyst coverage responsibilities for European and Latin American banks. Prior to joining the firm in 2003, Elaine worked at JPMorgan Chase as a credit analyst for five years and as an internal auditor for three years. She is based in New York and holds a BS from New York University.

About the Authors

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Preferred Securities

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Publication Date: April 2020 Copyright © 2020 Cohen & Steers, Inc. All rights reserved.

Index Definitions. An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes. Index comparisons have limitations as volatility and other characteristics may differ from a particular investment. Preferred securities: 60% ICE BofA U.S. IG Institutional Capital Securities Index, 20% ICE BofA Core Fixed Rate Preferred Securities Index and 20% Bloomberg Barclays USD Developed Market Contingent Capital Index. The ICE BofA U.S. IG Institutional Capital Securities Index is a subset of the ICE BofA US Corporate Index including all fixed-to-floating rate, perpetual callable and capital securities. ICE BofA Core Fixed Rate Preferred Securities Index tracks the performance of fixed-rate USD-denominated preferred securities issued in the U.S. domestic market. The Bloomberg Barclays Developed Market USD Contingent Capital Index includes hybrid capital securities in developed markets with explicit equity conversion or write-down loss absorption mechanisms that are based on an issuer’s regulatory capital ratio or other explicit solvency-based triggers. Corporate bonds: ICE BofA Corporate Master Index tracks the performance of USD-denominated investment-grade corporate debt publicly issued in the U.S. domestic market. Municipal bonds: ICE BofA Municipal Master Index tracks the performance of USD-denominated investment-grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions, in the U.S. domestic market. 10-year Treasury bonds: 10-year Treasury is a debt obligation issued by the U.S. Treasury that has a term of more than one year, but not more than 10 years.

Important DisclosuresData quoted represents past performance, which is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated herein will be repeated in the future, and there is no way to predict precisely when such a trend will begin. There is no guarantee that any market forecast made in this document will be realized. The views and opinions in the preceding document are as of the date of publication and are subject to change without notice. This material represents an assessment of the market environment at a specific point in time and should not be relied upon as investment advice, does not constitute a recommendation to buy or sell a security or other investment and is not intended to predict or depict performance of any investment. This material is not being provided in a fiduciary capacity and is not intended to recommend any investment policy or investment strategy or take into account the specific objectives or circumstances of any investor. We consider the information in this presentation to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of suitability for investment. Cohen & Steers does not provide investment, tax or legal advice. Please consult with your investment, tax or legal consultant regarding your individual circumstances prior to investing.Risks of Investing in Preferred Securities. Investing in any market exposes investors to risks. In general, the risks of investing in preferred securities are similar to those of investing in bonds, including credit risk and interest-rate risk. As nearly all preferred securities have issuer call options, call risk and reinvestment risk are also important considerations. In addition, investors face equity-like risks, such as deferral or omission of distributions, subordination to bonds and other more senior debt, and higher corporate governance risks with limited voting rights. Below investment-grade securities or equivalent unrated securities generally involve greater volatility of price and risk of loss of income and principal, and may be more susceptible to real or perceived adverse economic and competitive industry conditions than higher grade securities. Benchmarks may not contain below-investment-grade securities. Cohen & Steers Capital Management, Inc. (Cohen & Steers) is a registered investment advisory firm that provides investment management services to corporate retirement, public and union retirement plans, endowments, foundations and mutual funds. Cohen & Steers UK Limited is authorized and regulated by the Financial Conduct Authority of the United Kingdom (FRN 458459). Cohen & Steers Asia Limited is authorized and registered with the Hong Kong Securities and Futures Commission (ALZ367). Cohen & Steers Japan Limited is a registered financial instruments operator (investment advisory and agency business and discretionary investment management business with the Financial Services Agency of Japan and the Kanto Local Finance Bureau No. 3157) and is a member of the Japan Investment Advisers Association. Notes for Readers in the Middle East: This document is for information purposes only. It does not constitute or form part of any marketing initiative, any offer to issue or sell, or any solicitation of any offer to subscribe or purchase, any products, strategies or other services nor shall it or the fact of its distribution form the basis of, or be relied on in connection with, any contract resulting therefrom. In the event that the recipient of this document wishes to receive further information with regard to any products, strategies other services, it shall specifically request the same in writing from us.

About Cohen & SteersCohen & Steers is a global investment manager specializing in liquid real assets, including real estate securities, listed infrastructure and natural resource equities, as well as preferred securities and other income solutions. Founded in 1986, the firm is headquartered in New York City, with offices in London, Hong Kong and Tokyo.