Outlook 2015: Fed’s rate policies drive 2014 preferred stock results, will stay in play in 2015

By Stephanie N. Rotondo

Phoenix, Jan. 2 – The so-called “taper tantrum” of 2013 led preferred stocks into a “massive rally” in the first quarter of 2014, according to one trader.

As the year began, preferred stocks were on the rise. But come May, things leveled off, leaving the market “trading sideways,” he said.

While the taper hubbub had subsided, investors spent most of the first part of 2014 trying to figure out what the Federal Reserve planned to do with interest rates, as well as its quantitative easing program. But the Fed – which brought its QE program to a halt in October – made unclear remarks about when it planned to raise rates, citing the need for more positive economic data.

“Overall, I expected that we would see a weaker [Treasury] bond market because of an improving economy,” one trader said. “I expected a faster recovery. But we didn’t see that, so rates stayed very low.”

As Treasuries rallied, spreads tightened. Economic data continued to show only modest improvements and the Fed failed to give a clear picture on its path.

“There seems like there is a lack of leadership or direction,” one trader said. “So investors would rather sit on the sidelines in Treasuries.

“Better safe than sorry.”

Still, the low-rate environment resulted in a steady stream of new issues, though perhaps not as many as previously expected. And as some market players are forecasting that rates could stay low well into 2016, that could drive a more diversified field of issuers into the preferred arena come 2015.

A steady deal flow

The primary market in 2014 “wasn’t a blockbuster,” one Chicago-based sellside source said. “But it was pretty strong and steady. There was a decent slate of deals.”

One trader, citing Bloomberg’s league tables, noted that there were fewer deals in 2014 than 2013.

“I would have thought it was just the opposite,” he said.

A source noted that there was an “interesting mix within the space as far as listed bonds and preferreds go.” Banks were not necessarily dominating as per usual, he said, as some master limited partnerships (MLPs), real estate investment trusts and shipping companies entered the mix.

“I thought there was a mad rush to get these [shipping new issues] out at high yields,” another source said.

Those issues did fairly well, “then cratered when oil dropped,” he said.

Come 2015, “non-traditional issuers could keep coming to the market,” the source said, especially smaller shipping and energy companies, which typically issue to retail investors. And as those investors hunt for yield, they could be looking closer at the preferred space versus typical high-yield bonds, as there is more transparency in listed securities.

The entrance of non-traditional issuers into the market wasn’t the only trend in the primary arena during the year.

“There was not so much out of insurance companies,” a sellside source remarked, adding that those types of issuers might not have needed the capital. But new rules and regulations for such issuers – from both the United States and Europe – might have also been a factor.

For example, Europe has been working on the Solvency II Directive, which is slated to go into effect on Jan. 1, 2016. While not “concretely in place,” the new rules could be “holding up a lot of issuance” from names like Aegon NV, ING Group NV and Allianz SE.

However, that does not preclude such types of issuers from entering the market come 2015. The source said that by the second quarter of 2015, “they might have a better idea” of what the rules mean for them and they could come back to market.

In larger “traditional” issuers, the trend seemed to be a move to $1,000-par non-listed issues.

“There were not as many $25-par issues as I would have thought [from those issuers],” a trader said.

No-go on CoCos

One other notable difference in the 2014 primary arena was fewer deals that included the contingent convertible security (CoCo).

Back in 2010, there was “talk of starting back up all sorts of weird structures in European banks and insurers,” a trader said. “It all came down to regulations and how much loss provision was included.”

The CoCo emerged as a frontrunner of said “weird structures” and was being touted by many as the next big thing.

In a CoCo security, investors receive extra yield, a trader said, though he deemed it marginal, at best. But there was “massive downside risk.” If a bank or insurer was caught with a capital shortfall, the CoCo debt would get permanently converted into common stock – “at the worst time, when they are short on capital.”

And, “it is such an expensive way to [raise money],” the trader said.

As such, the structure “lost popularity with investors,” another trader said.

“They are going to have to do something different,” said a source. “It’s just not worth it.”

Kevin Conery, a preferred stock desk analyst at Piper Jaffray & Co., however, holds a different view.

The year saw record issuance in the CoCo space, he said, mostly from European issuers. He said he expected that area to stay active.

“Spreads might have to get higher to attract investors,” he noted. “But there is a strong corporate finance and regulatory need to issue them.”

While Conery conceded that “they are pretty volatile,” he opined that the particular type of security was “the cheapest form of tier I capital under Basel III” for issuers.

Rates stay in focus

As much as the Fed played a role in the performance of the preferred market in 2014, that will likely continue into 2015 as investors look for signs that interest rates will rise again.

“Eventually, we have got to raise rates,” said one trader. “All things being relatively equal, I think they are intimating pretty clearly that if things continue on the track they are on” rates could go up as soon as the end of the first quarter or the second quarter.

“Obviously, negative data points could alter that,” the source noted. But he opined that it would take “something relatively major” to curb that plan, even going so far as to say that the recent downturn in oil prices is “not enough at this point” to stop that train.

But a currency crash or some other geopolitical upheaval “could turn the timeline off.”

Another source predicted that rates might not increase until 2016, given geopolitical concerns and “the U.S.’s lack of foreign policy.”

In his view, the economy is not improving as fast as it should be and there are few signs of inflation – something the Fed has indicated it would like to see before it raises rates.

On top of that, Japan entered yet another recession and a growing number of analysts are forecasting a 65% chance of a recession in the United States in 2015.

In its last meeting of 2014, the Federal Reserve changed some language in its policy statement, switching “considerable time” to “patient.” In a press conference following that release, Janet Yellen, Fed chairwoman, said that the language alteration did not reflect a change in policy and also noted the central bank would not move to increase rates “for at least the next few meetings.”

If rates do go up, however, it will “cause more of a flattening of the curve,” a trader said. Long-bond rates “won’t get really out of whack.

“It should still be an attractive environment to issue long-term debt or perpetual preferreds,” he said.

With that, banks in need of more capital due to regulation changes could take advantage – especially as some still have old issues that have not yet been redeemed.

“Maybe we will see that start to clean up,” a trader said.

But Conery noted that banks have a limit on how much preferreds they can issue that qualify as tier I capital. “Some still have room to issue,” he said, pointing to JPMorgan Chase & Co. and Citigroup Inc. Some other banks, like Goldman Sachs Group Inc. or U.S. Bancorp, are full or potentially even over-issued, he said.

In particular, he said retailers might be interested in entering the preferred market.

Conery reasoned that “the U.S. $25-par listed market will probably not have a lot of issuance.” If that is the case, that could mean an uptick in $1,000-par issuance – especially as CoCo’s are not sold to retail investors.

Should rates stay at or near their record-lows, “it might bring some new players into this arena,” another trader said. “We could see an active year and we might see some new names.”

The oil problem

How oil prices move around in 2015 will also be topical come the new year.

“Oil and natural gas is going to be a big news item,” a trader said. The question on everyone’s mind is “how low does it go and does it settle into a range?”

Should oil settle into a sub-$50 range, “we could see a lot of cracks in high yield,” a trader said. “A lot of [exploration and production companies] could not raise money or service their debt.”

Fannie, Freddie in focus

The ongoing saga of Fannie Mae and Freddie Mac will likely remain in limbo in 2015 as shareholders continue to fight for their investments.

The drama of the government-sponsored entities hit a pivotal point in October, when lawsuits brought by investors such as Perry Capital LLC, Pershing Square Capital Management and Fairholme Funds Inc. were dismissed by a judge in the U.S. District Court for the District of Columbia. The lawsuits – filed against the federal government – alleged that the government’s takeover of nearly all of the agencies’ profits was illegal.

With the dismissal, it was effectively ruled that the government – acting as conservator of the mortgage giants – had the right to take those funds, thereby leaving investors with nothing in the event of a liquidation.

Investors did appeal the ruling.

Court rulings awaited

“On the legal side, we are going to see price movements in the common and preferreds with every little court ruling there is,” a trader speculated. Investors could take their arguments all the way up to the Supreme Court, he said, though he doubted that would occur until 2016 – or even later.

“So we are just going to [the preferreds] ebb and flow,” he said. “From here, they stay range-bound until the next major news item.”

“It is still going to come down to the courts,” said another source, expecting that a decision on the appeal will come in the first quarter.

If the appeal goes in favor of investors – allowing them to proceed with their cases against the government – “we could see [the preferreds] jump.”

Conery believes that the appeal might be the best chance preferred investors have to recoup anything.

“Their best hope is that there is a judicial ruling in their favor,” he said, opining that some form of a ruling should be seen in 2015.

Legislative fix unlikely

In terms of legislation aimed at winding down the GSEs, a trader deemed it “a political whim.

“It seems like too big a project for something to ever get done in the Senate,” he said.

Another trader echoed that sentiment.

“I don’t see how they could ever get that done,” he said. Because of Frank-Dodd regulations, banks are not likely to step up to fill any vacuum a liquidation of Freddie and Fannie would create. The private sector is similarly unlikely to take on the role of the agencies.

“No one would touch it because of the risk of loss,” he said.

The trader also noted that the government is “probably reluctant” to give up the cash flow Fannie and Freddie have been providing.

“They’ve been bringing in money hand over fist,” he said.

It will probably turn out that there is no way for the government to wind down the two entities, but it could change the structure, making it harder for taxpayers to be on the hook in the event of another crisis.

Conery maintained that preferred investors would likely get nothing if the government does in fact come up with a plan to unwind Fannie and Freddie.

“You have got to be pretty confident that you have a good legal argument that there is long-term value,” he said.

In his view, he thinks the saga will continue for at least the near-term.

“The path of least resistance is likely to be the status quo,” he said. “They will continue to shrink, as they have been shrinking.”

“Ultimately, I think this will be decided by the Supreme Court,” a trader said. “But I don’t think that will be for a couple of years.”

Trader: Preferreds attractive

Overall, the preferred stock market should remain an attractive market for investors in 2015.

One trader said that in particular, investors should be looking at high-coupon, short call preferreds, such as Wells Fargo & Co.’s 8% series J class A noncumulative perpetual preferreds (NYSE: WFCPJ). That issue is callable in three years, he said, and is trading with a yield in the high-6% area.

He noted that it is trading at 222 basis points to the call.

“It’s not great income, but it beats money markets,” he said.

He also suggested that investors “stick with fix-to-floats,” particularly in bank paper. Now that financial institutions have a majority of their legal issues behind them, “they are going to start cranking out a bunch of profit.”

Last but not least, business development companies could be the next sector to watch.

“We are going to see them do quite a bit of issues this year,” a trader said. “I think we will see that area grow and grow.”

More than likely, those issues will be structured as $25-par “baby bonds.”

Investors were looking for yield in 2014, given the low-rate environment and unclear cues from the Fed about how or when rates would move. That brought them to the preferred market and many sources believe that trend will continue into 2015.

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