Bank Preferred Stock Issuance Grows, Offers Alternative to Corporate Bonds

May 14, 2015

Bank Preferred Stock Issuance Grows, Offers Alternative to Corporate Bonds Photo

James Faunce contributed to this post.

This week's chart above indicates how aggressively bank and finance companies have been at issuing preferred stock over the last few years. These securities are being issued to meet U.S. capital and Basel III regulatory requirements, frameworks which govern bank capital adequacy, stress testing and liquidity. From a trading and total-return perspective, preferred stocks act similar to high yield bonds and often come with high yield ratings.

While bank preferreds have some duration sensitivity and performance is periodically impacted by new issuance, I view their longer term risk/reward as attractive. Underlying this view is a belief that bank fundamentals are sound, driven by lower leverage levels and enhanced liquidity positions. Moreover, asset quality (non-performing loans and charge-offs) continues to improve, underpinned by strengthening residential and commercial real estate values and lack of mega leverage buy-out deals. Banks still face headwinds in the form of low interest rates (which pressure net interest margins) and ongoing litigation. However, these concerns are more for the equity market and should not obscure the bigger picture of stabilized credit quality.

Given improved bank credit quality, bank preferred stock can be a good alternative to corporate bonds at this point in the business cycle. This is due to the event risk and shareholder-friendly posture of many management teams. Within the corporate sector, the upgrade to downgrade ratio has been declining, leverage levels have been creeping up, free cash flow is being utilized for share repurchases and dividends, and debt financed merger and acquisitions (M&A) are being used to augment sluggish growth. Furthermore, since banks will benefit more than industrial and utility companies in a rising interest rate environment and steeper yield curve, they offer a hedge against this outcome. Banks have their own fundamental challenges, but they are not subject to the same late-cycle behavior as the corporate sector. Thus, I am comfortable moving down the capital structure of solid investment grade bank and finance companies into their higher yielding preferred securities.

Key Takeaway: If one adheres to the adage that the cause of the next credit market crisis will not be the same as the last, banks should fare well on a relative basis when the cycle turns. Despite their current volatility, their beta to the market should dissipate as balance sheets strengthen, liability structure becomes more stable, and the extensive regulatory oversight they are subject to creates a more utility-like business model. Lower levels of profitability notwithstanding, these factors make for a more bondholder- and rating-friendly sector.

Tags: Chart of the Week | Corporate bonds | Preferred stock | Total return | Banking industry | Fundamentals

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