Why Preferred Stocks Are Attractive Yet Undercovered

Last week’s Behind the Markets podcast featured a discussion with alternative investment manager Moelis Asset Management and its subsidiary Gracie Asset Management. Their investments are focused on opportunities in the credit space, but our conversation focused on the hybrid and preferred stock asset classes as unique opportunities in today’s low interest rate environment.  

Some highlights of our discussion—and background information on the asset classes—include the following.  

Preferreds: Distinct Market and Structure

• Broad and Deep Universe: over $1 trillion in preferred stock outstanding, the highest level in history 

• Issuers are primarily regulated, large-capitalization financial institutions in the U.S. and Europe 

• Preferreds provide an investor with the ability to capture both debt- and equity-like characteristics as well as create asymmetric exposures (both long and short) to rates, credit spreads and curve shape with limited need for macro overlays and hedges. 

• Since 2008, banks and brokerage firms have relied on preferred securities to replenish capital that was depleted during the financial crisis. In Europe, the contingent convertible security (CoCo for short) increased from 2% of global capital securities to almost 25% in the past nine years.

The Preferred Market Is Deeply Underserved 

One topic we talked about is why Gracie and Moelis believe the preferred market is underserved by alternative and even traditional managers. Preferreds require specialized knowledge, given the complex and evolving nature of the market. Moreover, there is a coverage gap resulting from the hybrid debt and equity characteristics: many issuers are investment-grade companies with yields that are similar to the high-yield category.   

The End of 60/40

• Investors are grappling with the ineffectiveness of fixed income to provide complementary returns for portfolios that are highly correlated with equities.

• The typical 60/40 portfolios have traditionally benefitted from declining rates and negative correlation between bond and stock allocations.

• Preferreds have exhibited low correlations to U.S. Treasuries, a difficult relationship to find in fixed income.

• Preferreds also provide a relatively high degree of income with less risk and moderate correlation to equities. 

For those wanting to learn more about the preferred market, this was a very educational discussion; you can listen to the full conversation below.