European Bank Stress: What Does It Mean for the Preferred Securities Market?

Key Points

  • A proposed $14 billion fine for Deutsche Bank has led to concerns about the global financial sector, and spurred a modest drop in preferred securities prices.
  • Financial institutions issues make up a bulk of the preferred securities market. Bank stress can lead to heightened volatility for preferreds.
  • When investing in preferred securities, investors should be prepared to hold the securities over a long time horizon.

News of Deutsche Bank's proposed $14 billion fine by the U.S. Department of Justice weighed on global financial markets on September 16, 2016, and raised concerns about the strength of the global financial sector. Some preferred securities were hit especially hard, as the market is dominated by financial issuers whose coupon payments generally rank below those of traditional bonds.

While markets have since calmed on news that the settlement is expected to be well below the initially proposed fine, preferred securities may still be at risk of heightened volatility and potential price declines going forward. We still believe that preferred securities can help enhance investors' overall yields over long time horizons, but investors with shorter investing timelines should understand that prices may be volatile in the near term.

The proposed fine

Deutsche Bank's immediate struggles started in mid-September, when it was reported that the U.S. Department of Justice had proposed a $14 billion fine to settle an investigation into securities sales in the run-up to the 2008 financial crisis. The proposed fine was significantly larger than the fines that many U.S. financial institutions have paid in the years following the financial crisis, prompting Deutsche Bank to respond that it "has no intent to settle these potential civil charges anywhere near the number cited." Reports later emerged that that the settlement would be less than half of the initially proposed fine, but as of October 12, nothing had been settled.1

Two key risks: financial sector concentration and low priority of payment

Bank stress can have outsized effects on the preferred securities market for two key reasons:

      1. High concentration of financial sector issues, and

      2. Coupons on many preferred securities are discretionary.

Financial issues make up roughly 72% of the BofA Merrill Lynch Fixed Rate Preferred Securities Index, but less than a third of the sector's representation in the Barclays U.S. Corporate Bond Index.

Financial issues make up more than two-thirds of the preferred securities market

Source: Barclays and BofA Merrill Lynch indexes. As of 10/10/2016. Values may not add up to 100% due to rounding.

On the bright side, European financial institutions don't account for much of the U.S. investment grade preferred securities market—U.S. issuers make up more than 90% of the BofA Merrill Lynch Fixed Rate Preferred Securities Index.

While the preferred securities market is dominated by financial institutions, preferred securities also share characteristics of both stocks and bonds. Like bonds, they make scheduled coupon payments and have par values (usually $25) that are repaid at maturity or may be repaid early by the issuer. Like stocks, however, they generally rank below the issuer's senior debt. Due to this subordination, their coupon payments generally don't share the same characteristics as the coupon payments of senior bonds. In a bankruptcy, for example, corporate bond holders are paid before most preferred securities holders. And for many preferred securities, management can defer the coupon payments at their discretion, without triggering a default, if the company runs into trouble.

This subordination means that the price of preferred securities may be driven by factors in both the stock and the bond market. Historically, the correlation between preferred securities and U.S. stocks has been similar to the correlation with long-term Treasuries, highlighting that preferreds have both interest rate risk and credit risk.2

But correlations can change over time, and recently, preferred securities have been acting more like stocks than long-term Treasuries. Correlations with stocks have even risen above those with investment-grade corporate bonds, which have tended to be relatively consistent over each time period studied. With correlations with U.S. stocks currently elevated, ongoing stock market volatility could lead to more volatility in the preferred security market.

Over the past year, preferreds have been highly correlated with stocks

Source: Schwab Center for Financial Research with data from Morningstar, Inc. Correlations represent the average (1-year, 5-year and 20-year) correlations of rolling 12-month returns, using monthly data as of September 2016. Indexes represented are the BofA Merrill Lynch Fixed Rate Preferred Securities Index, Barclays U.S. Treasury Long Bond Index, Barclays U.S. Corporate Bond Index, and the S&P 500® Index. Past performance is not indicative of future results.

Coupon deferrals don't happen often. A few issuers suspended their preferred security coupon payments during the financial crisis in 2008-09, but they represented just a small fraction of the broad market. However, the concern that the coupon suspension would spread to more issuers led to a sharp decline in most preferred issues. The possibility of a coupon suspension, along with the lower ranking in the issuer's capital structure, are a few reasons why preferred securities generally offer higher yields.

As we saw after the Deutsche Bank news, it matters where an individual security ranks in the firm's capital structure. After the news of the proposed hefty fine, junior-ranking securities dropped more than those that were more senior in Deutsche Bank's capital structure. The lesson, as always, is that there's no free lunch. Even though these securities were all issued by Deutsche Bank, the ones that offered the highest yields also had the most risk, evidenced by the larger drop in price.

The lower the ranking, the larger the decline

Source: Bloomberg. Prices shown represent each day's closing price. For illustrative purposes only. No mention of an individual security should be construed as a recommendation or should be considered an offer to sell or a solicitation to buy any securities. You should not buy or sell any investment without first considering whether it is appropriate for you based on your own particular situation. Prices shown represent the day the fine was initially reported (9/15/2016) and the day prior to news reports that the settlement would likely be well below the initially proposed fine (9/29/2016).

One more threat—rising Treasury yields?

While the risk of financial market contagion appears to have abated, the potential for Treasury yields to rise from here could also lead to lower preferred securities prices. Since preferred securities share characteristics of both stocks and bonds, they are influenced by Treasury yields. Preferred securities tend to have long maturities or no maturities at all (meaning they may remain outstanding in perpetuity). Consequently, the prices and yields on preferred securities can be influenced by long-term bond Treasury bond yields.

While we don't think Treasury yields will rise sharply higher anytime soon, it's possible that the lows may be behind us. That may be the case with preferred securities as well. With the average yield-to-worst of the BofA Merrill Lynch Fixed Rate Preferred Securities Index near its all-time low as well, we think there may be more room for yields to rise than fall—meaning there may be less room for prices to rise from here. Going forward, we think much of the total return for preferred securities will come more from coupon payments, and less from price appreciation.

Although prices have declined over the past month, the drop has been relatively tame

Source: Bloomberg. Price declines represent the following time periods: 5/8/2013 through 8/19/2013, 1/5/2016 through 2/11/2016, and 9/8/2016 through 10/14/2016, respectively. Past performance is no guarantee of future results.

Keep in mind that the high coupon payments can help offset potential price declines over time. For example, while prices fell sharply in 2013, the total return for the full year was less negative, at only -3.65%. But total returns were 13.6% and 15.4% in 2012 and 2014³, respectively, illustrating the volatility that leads us to caution that preferred securities should be considered long-term investments only.

What to do now

While the reaction in the broad preferred market to the Deutsche Bank news has been relatively limited, it's possible that this could weigh on the market going forward. Increased volatility and broad price declines are possible. For preferred securities investors, we suggest:

  • Know what individual securities you own, and what types of securities they are. Preferred securities issued by low-rated, riskier issuers are more likely to see price declines during periods of market volatility.
  • Diversify. When owning individual preferred securities, we recommend holding at least 10 individual issues, with no more than 10% exposure to a single issuer.
  • Due to the complexities of the preferred securities market, a professional manager may make sense, as they have the resources to better navigate the market. We generally suggest that investors gain exposure through mutual funds or separately managed accounts.
  • Consider your time horizon. Preferred securities have both interest rate and credit risk, and tend to be more volatile than short- and intermediate-term, high-quality investments. Preferred securities should be considered long-term investments, and not be used if the funds will be needed in the short term.
  • Speak with a Schwab fixed income specialist. He or she can help you decide if preferred securities would complement your fixed income portfolio, and if so, what type of investing approach makes the most sense.

Next Steps

Talk to Us

To discuss how this article might affect your investment decisions:

-          Call Schwab anytime at 877-338-0192.
-          Talk to a Schwab Financial Consultant at your local branch.

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