Fixed-income investments come in all kinds of wrappers.
While traditional bonds are best known and fairly straightforward, other asset types such as convertible bonds, loans, and preferred stocks also offer a stated return over a set period of time. In this blog post, we focus on preferred stock, a corner of the market where we have found some interesting situations.
At slightly over $1 trillion, the preferred market is relatively small. And the mixed characteristics of these securities have led to differing views by the major ratings agencies about their impact on a credit rating. These conditions can occasionally create some interesting opportunities (and risks!) for investors like us who are naturally drawn to situations that the market is less likely to price efficiently.
And while preferred stocks will usually represent only a modest slice of our portfolio at most, we believe it’s worth highlighting some of their unique characteristics—and how we assess them.
Hybrids by Design
Preferred stocks generally straddle both the debt and equity sides of a company’s financing efforts.
Like bonds, most preferred stock issues offer regular cash payments to investors—although they’re technically dividends instead of interest—and may ultimately be redeemed at par, or their issuance price.
Like equity, preferred stocks may be bought and sold on the leading stock exchanges, and companies typically have more flexibility to temporarily suspend the payment of dividends.
From a seniority standpoint, preferred equity is outranked by a company’s bonds and other debt agreements but place higher than common equity. That means preferred dividend payments are more stable than those paid on common stocks, but not as protected as interest paid on bonds and other debt.
A Largely Untapped Source of Opportunities
All told, the preferred stock market is worth roughly $1.2 trillion, according to Cohen & Steers[1], which is less than 4% of the size of the global corporate bond market as measured by the Organization for Economic Co-operation and Development[2]. So, although the after-tax returns on preferred stocks tend to be attractive (due to the lower tax rate assessed on qualified dividends than interest income), investors often overlook the relatively small asset class.
In addition, preferred stocks are mostly issued by companies in the financial sector, as banks and insurance companies often use them to meet regulatory capital ratios. Therefore, it’s challenging to construct a diversified portfolio that consists entirely of preferred stocks. We think this leads to fewer investors focused solely on preferreds, which can in turn lead to less efficient pricing.
Source: Bloomberg, as of January 2022.
Other Non-Financial: Non-cyclical, Cyclical, Industrial, Basic Materials, Technology, Government, Diversified.
Other Financial: Investment Companies, Private Equity, Savings & Loans, Closed-end Funds, Diversified Financial Services.
Rating Agencies’ Shades of Gray
The ratings agencies’ lack of a unified approach to evaluating preferred stocks can be another source of opportunity—and risk—for fixed-income investors pondering a stake in preferreds. We believe this is especially true given the importance most issuers and investors place on credit ratings, which are also often tied to key clauses in the structure of bond offerings.
While each ratings agency treats preferreds more favorably than pure debt, the degree can vary widely. How disjointed is the thinking among the top three ratings agencies?
- Fitch assigns preferred stock to one of three buckets: 0% equity, 50% equity, or 100%. Accordingly, Fitch says that preferreds within the 50% and 100% equity buckets bolster a company’s leverage ratio, which refers to its debt load, although they diminish its coverage ratio, which accounts for all interest and dividend payments.
- S&P Global is more nebulous, assigning either high, intermediate, or no equity content labels on preferred stock. They start by looking at the legal structure of the issue and then explores the company’s intent behind the issue. Key factors include how company losses or cost-cutting measures will impact the preferred stock payout and the duration of the preferred issue.
- Moody’s framework contains no middle ground on preferred stock issued by companies it rates non-investment grade. An issue is either 100% equity or 100% debt. The only two deciding factors hinge on how preferred stockholders are treated if the company declares bankruptcy.
Specific issues can also differ. For example, we recently spoke with a management team that was evaluating whether to temporarily suspend payment of preferred dividends. They told us that one ratings agency viewed that negatively, while another viewed it positively.
The differing methodologies reinforce the lack of a black-and-white industrywide approach to addressing hybrid securities within a company’s credit rating, which can be exploited by issuers as well as diligent investors.
Ratings as Opportunity
From time to time, the hazy rating methodology can lead to opportunities.
For instance, take our past investment in the preferred stock of an oil and gas company. The security offered a materially higher yield than what a new bond issue would have featured. All else equal, we would expect the company to refinance the expensive preferreds with cheaper bonds, thereby lowering the total cost of capital. As we dug into the situation, however, we discovered that the company was hesitant to do this because the resulting higher debt load would lead to a downgrade in the company’s credit rating. For this management team, the superior credit rating trumped a lower cost of capital.
Whenever non-economic factors influence the price of a security, we have found that it often creates the chance to earn excess returns. Relatively confident that this particular company would keep paying out the higher dividend on the preferred stock, we made the investment.
Ratings as Risk
Conversely, risks can arise when a company issues preferred stock in lieu of bonds for the favorable treatment by certain ratings agencies. Even though capital structure and creditworthiness would generally be the same, the difference in ratings can create circumstances in which the ratings methodology can be “gamed” by sophisticated issuers to the detriment of creditors.
Take, for example, the case of a retail business we researched recently that was mulling a buyout offer from a private equity (PE) firm. The retailer had issued bonds years earlier when rates were lower, and these bonds traded at a large discount to par at the time the offer was made.
Most bonds have a “change of control” right that allows investors to sell them back to the company at 101% of par in the event of a buyout. Sometimes, companies will add an additional requirement that the bonds also need to have their rating(s) downgraded (“double trigger”), which was the case for this retailer.
The majority of PE acquisitions are leveraged buyouts (LBO) that result in riskier capital structures and would typically lead to a ratings downgrade that would trigger the right for bondholders to sell them back at 101. In this case, however, we learned that the PE firm bidding on this retailer was contemplating a transaction that relied heavily on preferred stock.
Why would a PE sponsor raise preferred stock instead of turning to the more liquid leveraged loan and high yield bond markets?
One possible explanation is that preferred stock would be treated more favorably by ratings agencies, which could allow them to engineer an LBO-like structure that was less likely to trigger a ratings downgrade. Without a ratings downgrade, the sponsor could perhaps avoid refinancing some of the retailer’s cheaper bonds that were outstanding. Bondholders expecting to recover 101% would be left sorely disappointed.
Still Subject to Our Rigorous Analysis
How much does a rating agency’s treatment of preferred stock matter in our analysis?
Frankly, not much.
We base all of our investment decisions on deep analysis, independently judging the investment merits of a company’s preferred stock, bonds, or any other asset regardless of what the ratings agencies say.
And yet, specific to preferred stock, we’re well aware of risks that can arise when companies exploit their treatment by ratings agencies to their benefit.
Keeping that in mind, our focus remains on finding a preferred risk/reward profile for income-focused investors.
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