The Case for Preferred Securities

Jeff Buchbinder:

Hello everyone, and welcome to the latest LPL Market Signals podcast. Jeff Buchbinder here, your host for this week, with my friend and colleague Lawrence Gillum, here to talk fixed income, and probably a little more than that. How are you today, Lawrence? Thanks for joining.

Lawrence Gillum:

I'm doing great, Jeff. Thanks for having me back on the podcast. Really excited to talk about some preferred securities later.

Jeff Buchbinder:

I think that sounds really good. We've been recommending preferreds for a while, and I bet some of our listeners are interested in an update. So it is May 13, 2024, as we're recording this. The after we look at these lovely disclosures, we'll show you the agenda. There it is. We're going to start by just recapping the market action last week where it was a strong week for stocks, first of all. And secondly, we are getting really close to a new all-time high for the S&P 500. That's exciting, but not as exciting as this interesting idea for income in the bond market, which is preferreds, as we just alluded to. Related to preferreds, but a topic that I think a lot of people are interested in is commercial real estate. You know, if you buy preferreds, you're buying a lot of bank exposure or financial services exposure broadly.

Jeff Buchbinder:

So Lawrence is going to tell us if we should be worried about commercial real estate, given we have so many offices with vacancies. And then lastly we'll preview the week. It's not just CPI, there's a couple other things going on. We'll get to that as well. So to recap last week, the S&P 500, up about 2%. So a solid week. I think the main topic of discussion around last week's market activity has been utilities. You see here, utilities up 4% last week. You know, part of that is certainly the market wanting to get a little more defensive, which we've seen since we hit the all-time high at the end of March. You know, part of it is probably a recognition that maybe yields have topped. We'll show you a 10-year yield chart, and Lawrence can weigh in on the outlook for Treasury yields.

Jeff Buchbinder:

But then part of it is also this AI kicker, right? The power demand needed by data centers powering AI is enormous. And so you're getting a little bit of a AI kicker in utilities. So really strong. Utilities are the best performer in Q2. Consumer staples have also been among the leaders in Q2, so that you know, is kind of giving more credence to the shift to a little bit more of a defensive sector mix. Although communication services is done really well in the quarter and is a little bit more of an aggressive or offensive sector with Alphabet and Meta in there, making up almost half the sector. So you know, last week saw some defensives do well, but also saw financials do well. So that's a good sign. Suggests we're broadening out beyond tech. You know, it's not good when tech lags, but if you're waiting for broadening it is.

Jeff Buchbinder:

So tech was only up about 1.5% last week. So you ended up with a little bit of a value out performance relative to growth. We're kind of balanced on the two with a slight lean to growth. Regionally, we had pretty good gains in Europe last week. Think, you know, part of it is that the ECB is probably going to cut rates before the fed. Part of it is also you've seen some signs that maybe the economic conditions in Europe have bottomed. I think we've seen that in particular in the U.K. And, you know, earning season over there has been pretty good. So you know, we're neutral on developed international, have liked Japan more than Europe, but that gap is closing, no doubt. You know, Japan has really struggled with the yen madness. The yen's kind of stabilized the past few days, but certainly the Japanese stock market has cooled off just a bit.

Jeff Buchbinder:

What hasn't cooled off is Hong Kong and the big tech names, actually a couple of them report earnings this week, Alibaba and Tencent. So you saw a really nice gain in Hong Kong, which has led those Asian indexes. Asia I'm talking about China and Hong Kong indexes to make up a lot of ground. And now you know, actually have generated pretty good returns year to date. The Hang Seng up 12. And the Shanghai up about seven. So, moving along this is your page, Lawrence, bonds. What do we hear? What do we see from the bond market?

Lawrence Gillum:

Yep. So last week was a kind of call it a muted week. Although if you strip out Friday, which of course you can't do, it was a good week. But Friday we had some disappointing inflation data in terms of near-term expectations for higher inflation over the next year that was a survey that was released on Friday that pushed yields higher, prices lower. So that kind of erased the previous four days of decent returns. So net net, we ended up the week positive, but just barely. So it was good to see though, that mortgage-backed securities outperformed again, albeit a slightly positive week, but it has out, it did outperform treasuries and the investment-grade corporate bond market, which as you know, listeners know that we've been pretty optimistic on mortgage-backed securities given valuations.

Lawrence Gillum:

The other area, of course, that we've been optimistic about is preferreds. They're up about 4%, call it this year, 13% over the past I'm sorry, 3% over the past year to date period, 13% over the past year. A lot of the gains may have come already, but we still think there's a good story for preferreds. We think that with current yields still above longer term averages the preferred sector could be another attractive one over the course of the next couple quarters. So we'll talk more about that a little bit later on. But by and large, kind of a, this, a similar type story within the plus sectors versus the high-quality core sectors. Plus sectors continue to do well and continue to really price in this soft landing narrative.

Lawrence Gillum:

Whereas these kind of core sectors are more interest rate sensitive, and with the expectation of still solid, perhaps slowing a little bit, but still solid economic growth any sort of fall in interest rates it's kind of been pushed back in terms of interest rate cuts as well. So, the story's been a pretty similar one throughout this year. It's the riskier segments of the fixed income markets have done well, and the high-quality segments have kind of been stuck in a range, if you will given the expectations of fewer rate cuts throughout 2024. So the narrative hasn't shifted, but you know, we do think at the end of this year, those returns for a lot of these fixed income sectors are going to be positive ones.

Jeff Buchbinder:

Yeah, we've made some progress, right? I think the Ag the, you know, the bond market index was down something like three and a half at one point year to date at the lows. I may be a little off on that, but, so we've, you know, culled some of those losses and have made some progress. I think it's also worth noting that the correlation between stocks and bonds is kind of returned to normal, I guess, or returned to what we've seen recently anyway, which is the lower yields has helped the stock market lately. So that was, you know, the return to Goldilocks, some people are calling it, you know, increased up chances of a soft landing because you know, now we're pricing in a couple of Fed cuts. Job market has cooled a little bit based on the recent data.

Jeff Buchbinder:

We even got a weak consumer confidence number on Friday that caused folks to, you know, maybe sort of price more cuts in. And you know, it looks like the odds well, and Powell took a hike off the table, right? So you kind of put all that together it looks like you know, the bond market's more comfortable and that makes the stock market more comfortable. The I think on the commodities front, you know, what you're seeing, you know, solid gains in industrial metals, solid gains in precious metals is, maybe the dollar run is coming to an end. We'll have to see. I mean, partly depends on the yen, which was down a little bit last week, but certainly not as big of a move as some of the moves we've seen in prior weeks. So you know, the dollar is certainly a commodity driver, but you also have better economic data in China recently.

Jeff Buchbinder:

And I mean, there's still prospects for more stimulus, but mainly it's just if you follow, not over the weekend, but if you follow the economic data in China over the last couple of months, you know, maybe similar to Europe, you're seeing you know, maybe evidence of that a trough is in. So, that's been pretty good for commodities generally recently. So here's your S&P 500. I threw the breadth statistics in here because I thought they're kind of interesting. So you see here, we're really close to an all-time high, within about a percent, which of course is good news, and we've got these nice, you know, uptrend lines that you can draw. But, you know, the criticism about prior rallies has been that it's been too narrow, just driven by the big tech stocks.

Jeff Buchbinder:

The bottom panel here shows you that that is not the case because we have 77% of S&P 500 names above their 20-day moving average, which is a really high reading. You know, you look back at this is just a three year look roughly, but you look back over this period, and that's a pretty good reading. And then 79% of S&P 500 stocks over their 200-day, also are really good reading. So it's not just big techs participating. So you know, next is the 10-year yield. And Lawrence again, I think the market's gotten more comfortable owning the 10-year and that's made people more comfortable with stocks. When you look at this chart, either, you know, technically or just fundamentally, do you think the highs are going to hold from you know, I guess it's, the recent high was about 4.70.

Lawrence Gillum:

Yeah. Absent any sort of reacceleration of inflationary pressures you know, we do think that the top is in. Particularly because of what you just mentioned about Jerome Powell, Fed chair taking seemingly taking rate hikes off the table. His story is that the fed funds rate, the short-term interest rates, are in restrictive territory. So his story is that worst case scenario, it just delays rate cuts and not, it not actually increasing rates further from current levels. So absent a spike in inflation, unachoring of inflation expectations that may cause the Fed to backtrack and put rate hikes on the table again we do think yields are kind of at really at levels that they're likely going to be at for the foreseeable future until markets get comfortable about these upcoming rate cuts that are priced in markets are thinking a rate cut could happen in September or November perhaps a second rate cut in December.

Lawrence Gillum:

So if there's any data that deviates from that narrative, we could see rates move a little bit, but I think we're going to be in these current levels for the foreseeable future. We do think the 10-year Treasury yield ends the year lower than current levels. So maybe we get down into the 4% level but absent any sort of large financial crisis or any sort of geopolitical events which is, you know, certainly not one of our base cases, but something that is seemingly always out there but we don't think we're going to get back into the kind of mid to low threes anytime soon. We're kind of in this higher for longer environment, again, for fixed income investors, which is it's actually not a bad environment.

Lawrence Gillum:

It's actually a really good environment for fixed income investors. If I could plug my space real quick. Because you are getting a lot of income right now, you, I mean, you may be not getting a lot of price appreciation for fixed income markets right now, but you are getting a lot of income, particularly relative to history. So despite the fact that we may not see lower yields you know, that's I would argue, a good thing for the durability of fixed income as an asset class. My commercial's over now.

Jeff Buchbinder:

Sure. Well, you know, hey, when you're on this podcast, you can, you know, promote whatever you want to promote. So by all means do it. I guess you know, I mean, fixed income's obviously been tricky, but, you know, higher yields typically mean better returns. You just have to watch maybe the short term paper losses, right? But this economy has already slowed, and we're seeing some evidence that it's probably going to slow a little bit more. We're not talking recession, we're not talking hard landing. But you know, consumers have drawn down their excess savings and the job market has weakened just a tiny bit. So you know, the odds probably suggest that the economy, the trajectory of the economy, will put a little bit of downward pressure on yields. And we also did get through a lot of Treasury auctions without any up move in yields, which was good to see.

Lawrence Gillum:

Yeah, I think the point about Treasury auctions is an important one. I know we've written about it over the last couple quarters. It's kind of a boring topic, if you will, but the amount of debt coming to market over the next couple years is going to be an important barometer of how the fixed income market goes. If those auctions aren't well received, then we're likely going to see higher yields to attract that increased demand to offset the increased supply of Treasury securities. So, so far so good. We're not seeing any sort of pushback from markets or the so-called bond vigilantes yet. But it's something that we are certainly paying attention to for sure.

Jeff Buchbinder:

Yes, absolutely important to watch. Glad that that was not disruptive last week. So let's turn to preferreds as an interesting income idea. I mean, my guess is many of our listeners have not you know, traded preferreds or owned preferreds because it's not, you know, it's not a core fixed income category, I guess. So I know in this Weekly Market Commentary that for this week you, you know, provided an overview, maybe, you know, a short version of what you know, what are preferreds, you know, kind of how do they behave? You know, why should people own them? Maybe kind of start there and go from there.

Lawrence Gillum:

Yeah. So we were just talking about income opportunities and, you know, maybe the absence of price appreciation through falling yields. And preferreds are a great example of the amount of income you can generate in some of these, kind of call it non-core fixed income sectors. So I think a lot of investors, particularly the older set of us that remember preferred securities as these boring kind of fixed rate perpetual securities that are never called or never redeemed. So they're just out there forever. That's not the case anymore. Since the Global Financial Crisis, the preferred security market has changed fairly dramatically. In fact now there's really three main markets within the preferred sector landscape that investors can take advantage of. You have your retail $25 par securities, you have your $1,000 institutional securities, and then you have these securities called contingent capital securities that were really birthed after the Global Financial Crisis.

Lawrence Gillum:

And these are primarily non-U.S. issuers. But these are securities that are generally speaking, higher yielding because they do have additional risks associated with them. One of the things about these contingent convertible securities, we call them CoCo because everything has to have an acronym apparently, but we call them CoCo securities, and they tend to offer higher yields because they do tend to have additional risks not associated with the other two markets. The chief risk is really the fact that if the issuer is in some sort of financial stress or distress regulators can wipe out your investment completely or they can kind of convert it to equities. So there is that risk. It hasn't been triggered a lot over the last couple years, but there is that risk out there. But nonetheless, the point of this slide really is to show that it's a market that has grown in three different directions, your institutional market, your retail market, and your kind of your non-U.S. Coco market.

Lawrence Gillum:

And what's interesting about these three markets is that you can have one issuer participate in all three of these markets. So, it's kind of a complicated story, unlike years past where preferreds, again, were kind of boring, but now it's really complicated. And it really, in our view, points to the need for active managers that can kind of differentiate amongst these different markets and take advantage of these relative value opportunities within each individual space. But what hasn't changed, and we can go to the next slide, is really that these are just, these are securities that are primarily issued by financial institutions, banks, insurance companies, real estate issuers. These are the primary issuers of these securities. They're really incentivized to issue these types of securities because of these bank regulations.

Lawrence Gillum:

And that really, again, were born out of the Global Financial Crisis and some of the regulations there, but the financial institutions are the biggest issuers, have been. So really how this market behaves is really dependent upon the financial sector broadly, which is why we started to talk more about this commercial real estate issues out there that are continuing to make headlines. We'll talk about that in just a second. But so it's really very focused on the financial sector. I think the next slide is going to look at valuations. Right?

Jeff Buchbinder:

That's right. Move ahead.

Lawrence Gillum:

There we go. All right.

Jeff Buchbinder:

Before you go further, Lawrence, I added up those pieces. It's 76% financials, if my math is right.

Lawrence Gillum:

Yes. And what's interesting is you do get some kind of smaller issuers out there, but by and large, and we're going to talk more about this in just a second, but it's a lot of these large banks, these varied, well-regulated, well-capitalized banks but these securities, because where they sit in the firm's capital structure, they're above the equity portion of a company's capital structure, but below bonds. So they are these hybrid securities and in order to entice demand, they do tend to offer higher yields. And what we're looking at now is that at round 6.7%, higher than what we've seen over the last decade for this market. And so very attractive yields for kind of your less risky issuers. If you compare the preferred security issuers to things like high yield or bank loan or even emerging market debt. The issuers are a lot higher quality than what you would get in some of these other markets, but they're trading around similar type yields, so you don't have to give up a lot of income to invest in these securities which we think is pretty attractive offer right now.

Jeff Buchbinder:

Yeah, some of the biggest, strongest banks in the country, indeed, pretty good preferred yield. So nice opportunity for some income. But of course, if you're investing in banks, maybe not the biggest and strongest banks, but if you're investing in the banks that are, you know, maybe a tier below that, you probably want to think about the risks. Yeah. and the balance sheets. And so that's where commercial real estate comes in. So you know, everybody, Lawrence, talks about the empty offices when they talk about commercial real estate. So, you know, I guess the question is how do you, how do you assess that risk? You know, and how could this potentially be a big enough problem to affect the preferred market?

Lawrence Gillum:

Yeah. So, we brought in some outside experts to talk about these very things within our Strategic and Tactical Asset Allocation Committee here at LPL. And you know, we've kind of gone through the work, we've done the research ourselves as well as brought in these outside experts. And really the takeaway is that the commercial real estate landscape is much broader than what we see in the office space currently. So this is delinquencies of 30 days plus of delinquencies for these commercial real estate loans. And you can see that office loans, the delinquencies have spiked above 6%, likely headed higher as long as interest rates are high. So we could see additional stresses in the office commercial real estate market but even absent that, or I'm sorry, even including that spike that we've seen in the office real estate market, we haven't seen the same sort of delinquencies in the broader commercial real estate landscape.

Lawrence Gillum:

So we would argue and of course the data supports us, that this is really an isolated event within the office, CRE market and not the broader commercial real estate market. So, there's going to be challenges. There's going to be stresses and distress for some financial institutions. But if you want to go to the next slide, it's really isolated to a lot of these regional smaller banks that don't really make up a big component of preferred securities indexes. So depending on the indexes, these regional banks, which own over 60% of the office loans outstanding. So these are the ones that have underwritten the loans for a lot of these office properties that are sitting on these bank balance sheets. They're really isolated to these regional or local banks. And these local banks don't really participate in the preferred securities market, depending on the index, you're looking at a high single digit, low double digit percentage of regional or local banks that issue preferred securities. Most of the issuance is in this large money center banks, these JP Morgans, the Bank of Americas, Citigroup, et cetera. So and they have very really very little exposure to the office CRE sector. So, it's concerning for a lot of financial institutions, but it's primarily focused on these smaller banks and not the big banks that we're investing in when we invest through preferred securities

Jeff Buchbinder:

And in private equity, probably not much of a risk to the preferred market either. I know that there's some ownership of properties in private equity. So, so yeah, this doesn't mean that the office sector's a great investment, it just means that it's small enough that it's probably not going to, you know, meaningfully impair the value of the preferred market.

Lawrence Gillum:

Right. The preferred market that we're investing in, again, is these large national banks. The ones that have these really, we would argue fortified balance sheets. The ones that have post Global Financial Crisis have really been regulated to the point where they act like utilities in terms of just all the regulations that are imposed upon them. So which makes them safer, which the regulators have done their job for these big national banks. They've made these banks safer. But in the meantime, you're getting these yields associated with these preferred securities that are really attractive relative to history. So, it's one of those scenarios where you know, we got that baby in the bath water scenario where a lot of investors just kind of sold their preferred securities after what took place over a year ago with Silicon Valley Bank and the others. And right now, you're seeing really attractive yields for you know, these higher quality banks.

Jeff Buchbinder:

Yeah. And I would also argue the rest of the commercial real estate market is pretty healthy. Yes. I mean, hotels, you know, a lot of hotels are getting good prices and they're pretty full these days. And certainly retail, we know just from watching consumer spending the last couple years that that is certainly healthy and industrials tied to e-commerce. Right. You know, a lot of warehouses. And we know certainly how much e-commerce has been going on the last couple years, <laugh>. So the multifamily, I mean, there's a shortage of homes to buy but that doesn't mean they're not building a lot of apartments. And so I think the multifamily market's pretty healthy as well, frankly. So overall, I mean, this is why the delinquency in the numbers for broad commercial real estate are okay. That's right.

Jeff Buchbinder:

Because the rest of the market is just fine. So really, really good stuff, Lawrence, you know, helpful data to give people perspective and you know, share why we're confident still owning preferreds at this point. So thanks for that. Let's move on to preview the week ahead. And there's a lot of meaningful data this week and we actually have some meaningful earnings reports. It's not on this slide, but we also have the Japanese GDP report coming out on Wednesday. So you know, that'll certainly get a lot of attention. There's already a lot of attention on Japan. Actually, consensus is for the Japanese economy to contract, which is interesting with the yen so weak, you would think export growth would keep that economy going. But they have at least seems to be a little bit of a weak demand backdrop locally.

Jeff Buchbinder:

But at any rate, and then we get Walmart, you know, the earnings that matter. I think Walmart and Home Depot and Cisco, the networking equipment maker. But there's not a ton of companies. It's just seven. I think we actually get a little bit more next week as earnings season winds down. It's been a very good earnings season, really almost any way you slice it. I'll let you weigh in on this data Lawrence, but I just want to point this out because I think it's really impressive. And I think I mentioned this last week, but if you take out Bristol Myers, because they had a huge loss, I think it was a $12 billion loss when they absorbed an acquisition and that loss, it was so large that it actually took almost 3% off of S&P 500 earnings.

Jeff Buchbinder:

So you know, S&P 500 earnings are tracking to like 6%. But if you take out that one company and that loss is not going to, you know, recur forever. But if you take out that one company for Q1, you're tracking a nine, 9% year over year earnings growth, which I don't think anybody was expecting when earnings season began. So that's just one number. There are others, but that's one number that I think people should think about in terms of why this market's doing as well as it is. It's partly the economic picture, you know, evidence that maybe the Fed won't hike, maybe they'll cut twice. You got cooling inflation, cooling labor market, that's all helped. You know, the dip in bond yields, that's all helped stocks, but don't overlook the impact that earnings have had because the numbers have been excellent. In fact, the average company surprised by 7% plus and estimates for the rest of the year have actually inched higher a little bit. That's pretty rare. So anyway, that's enough about earnings. So what should we be watching for in terms of economic data here, Lawrence? I know it's CPI week.

Lawrence Gillum:

Yeah. And that's going to be the big story, right? On Wednesday we have CPI. The expectation is that we'll get slightly softer data than we've seen in the prior months. So we're looking at a year over year figure for headline CPI around 3.4% core. So you strip out the more volatile food and energy sectors and you're looking at 3.6%. Those are still above the Fed's 2% target. But you could really argue, again, moving in the right direction, albeit maybe a little bit slower than a lot of people were hoping for. But progress nonetheless. Retail sales is getting some press as well. Retail sales looks at primarily goods spending. And it does flow into our economic growth numbers, our GDP numbers. So I'm sure markets will be paying attention to that, but it's really the inflation story. Now, Chair Powell does talk, I believe it's tomorrow, if not tomorrow, it's Wednesday, but he'll be presenting as well. So, there's always the risk that markets take his comments out of context or you know, maybe try to read in too much into these Fed speaker's comments. But at the end of the day, it's going to be about the inflation story.

Jeff Buchbinder:

Yeah. And it's nice to be in a position where if you're just in line on the numbers, then the year over year gets better. Mm-Hmm, <affirmative>

Jeff Buchbinder:

Right? Now, I mean, we could have a miss. I'm a little bit hesitant to predict the data because I was wrong on the last jobs report. I thought we'd be, you know, the trend has been above expectations for a while and then we got that big jobs miss. So not going to make a prediction, but it's nice that, you know, if we get a 0.3 month over month on the core, then you know, that can translate into a 20 basis point improvement in the month over in the year over year on the core, which is what everybody watches. Now, the PCE reading matters more. That's what the Fed pays attention to. But the CPI, we've seen it over and over this year is a potential market moving data point. One of the most important data points we get, especially in an environment where everybody's so focused on the Fed and so focused on inflation.

Jeff Buchbinder:

So hopefully that number will cooperate. And we'll you know, keep the momentum going and maybe break to a new high. At last check. It's you know, it's Monday afternoon as we're recording this at the last check we were, you know, kind of flattish, but so we might have to wait a day for a legitimate shot at a new high, but or two if we wait for CPI, but if these numbers cooperate this week good chance with the momentum we've got, with the breadth, we've got that stocks keep going higher. Maybe we're setting up Lawrence for another Midyear Outlook where we write it and then we have a big move in the market one way or the other right after it's out.

Lawrence Gillum:

Yep. That's the challenge of writing your Midyear Outlook, which our first draft is due on Wednesday, so maybe we'll wait to see how the data unfolds on Wednesday before submitting.

Jeff Buchbinder:

Write fast, write fast <laugh>. So the other number I highlighted here, while retail sales you know, it's probably too early to get the impact of the dwindling excess savings, but, you know, retail sales is expected to slow a little bit in the April reading compared to March. But initial jobless claims is more important now after you got that pop last week. So we'll be watching that one really closely. And I think if you get another move higher there or even something flattish, the market's probably going to start put more pressure on yields and, you know, believing that that one weak jobs report is maybe a sign of more to come, we'll see. So a lot to watch again, Japan GDP and earnings in addition to this data. So I think that's all we got. So with that, I'll just thank you Lawrence, for joining. Thanks everybody for listening to LPL Market Signals and we'll be back next week where we'll certainly recap the CPI report and you know, probably do a little bit more on earnings as well. So we'll see you then. Take care everybody.