Outlook 2016: Preferred stocks outperform in 2015; Fed’s rate move could bring volatility in 2016

By Stephanie N. Rotondo

Seattle, Dec. 31 – The preferred stock market fared “quite well” in 2015, a Chicago-based sellside source told Prospect News. But looking ahead, more volatility is expected.

The positive performance of the space in 2015 came despite “continued pressure that [the Federal Reserve] was going to raise interest rates throughout the year,” the source said. Each time the central bank delayed the increase, “preferreds held in there.”

When broken up into $25-par and $1,000-par branches, however, the former performed much better than the latter, according to Kevin Conery, a preferred stock desk analyst at Piper Jaffray & Co.

The $25-par side of the market had “a pretty impressive year overall because it was being driven up for so long to higher levels,” Conery said.

Using the Wells Fargo Hybrid & Preferred Securities index, the year-to-date total return for $25-par issues as of mid-December was 5.78%.

“Not so bad,” Conery said.

But for $1,000-pars, the year-to-date return was 1.265%.

“The price appreciation has actually been negative,” Conery noted.

Again, the Fed and the ongoing “will they or won’t they?” interest rate saga was pointed to as a key driver. Each time the Fed made no move on rates, “it seemed to make the retail buyer a little more comfortable, especially in a period of time when fixed-income yields are so low,” Conery said. “So they look for where they could get additional returns,” which just happened to be the $25-par market.

As such, Conery estimated that it was retail investors who helped to drive up the market, largely through ETF trading.

“We don’t know that for sure, but ETFs are either at or near historic highs,” he noted.

But even as the preferred space outperformed other sectors of the financial markets, the end of the year brought more volatility as expectations were that the Fed would finally “lift off” and raise rates come December. “Some of the volatility in the high-yield market also spilled into the preferred market.”

On an index basis, Conery remarked that the Wells Fargo Hybrid and Preferred Securities index hit its high at the end of November. After that, it was “mostly downhill.”

2015 primary: Fewer $25-pars

Despite the overall outperformance of the $25-par market, it underperformed in terms of new issuance for the year.

Through mid-December, total new issuance in the preferred realm – including $1,000-par deals – stood around $73 billion, according to Conery. But of that, $25-par deals made up just less than $14 billion.

“So it was much smaller than the whole,” he said.

Conery also pointed out that $25-par deals were, on average, smaller than those seen in 2014.

The lack of $25-par new issues was attributed to a couple things. First and foremost, the Fed and the potential for a rate increase.

“It was harder to do bigger fixed-rate deals with people expecting the rate increase,” Conery said.

This was evidenced in how deals flowed through the year, he said.

For the first few months of 2015, he said, the deals that were coming out of the pipeline were heftier. In March, the Fed held rates steady but alluded to a possible increase come June. That impacted new issuance.

Once June hit, and no increase was seen, deals were flowing once again. But come October – just one month after the Fed maintained near-zero rates once again but indicated that a December hike was very likely – issuance “just faded,” Conery said.

For the rest of the year, the $25-par deals that were coming were “tiny.”

There was another factor playing into the low issuance of $25-par paper and that was the traditional prevalence of the fixed-to-floating interest rate. The greater dissemination of fixed-to-floating rate preferreds helped to keep investors interested in the $25-par primary market, Conery said. Furthermore, he noted that there were a few $25-par fixed-to-float issues that came to market, “and with good reception.” And, it was those fixed-to-float deals that were able to come at larger sizes.

The sellside source also noted that issuance in $25-par paper was “significantly less,” despite there being “quite a few redemptions.” He opined that issuers opted for $1,000-par offerings more often than not because “the cost of putting $1,000-par issues out to institutional buyers is less than putting them out to retail.”

Volatility and the Fed

On Dec. 16, the Fed elected to increase interest rates by 25 basis points for the first time since 2006.

Rates had been at or near zero since 2008.

Though the increase was widely anticipated, what it means for preferred stocks in 2016 is not as clear.

One source said that the “forward-looking language” from the Fed’s decision will be something the market will focus on. Will rates continue to increase over the year, or will they stay steady for some time until the economy grows stronger and signs of inflation are seen?

According to the Fed’s statement, future increases will be gradual and dependent on the strength of the economy.

“The committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the Federal Funds rate; the funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run,” the Fed said in a statement following its decision. “However, the actual path of the Federal Funds rate will depend on the economic outlook as informed by incoming data.”

“It’s an issue for the coming year, no doubt about it,” Conery said of the rate increase drama. An increase could initially “be perceived as bad,” he said.

“But it’s not an all-bad situation,” he pressed.

For one, it could be deemed a good thing for floating-rate issues. Secondly, it could help to improve the “creditworthiness” of banks.

“Profitability has been tough [for banks] because of the low-interest rate environment,” he explained.

Another source predicts that the rate decision could result in more volatility in the market, certainly in the first quarter. But if signs of inflation and economic improvement grow, “it gives the Fed justification for another rate hike,” he said. And more volatility would be sure to follow, given that there is “no depth and support in the market.”

2016: More $1,000-pars

The primary space in 2016 is meantime expected to continue to trend toward the $1,000-par side.

Meanwhile, $25-par issuance will be “manageable and on the low side,” Conery forecast.

Among big banks – typically the largest issuers in the preferred arena – new issuance “will be down a lot,” Conery opined. That is mostly due to the fact that most of them – Citigroup Inc. being a notable exception – are “bumping up toward their regulatory limits.”

But that could bring more large regional banks to the table “as there is more space in the market,” he said.

“It still makes sense to issue preferreds, assuming you are still within your regulatory limits,” Conery added.

Conery also speculated that most bank issuance will likely come in the $1,000-par area.

Redemptions of existing issues could also pick up in 2016, another source said, which will drive the need for companies to enter the preferred market yet again to raise capital.

“I’m surprised we didn’t see more redemptions [in 2015],” the source said, especially given the amount of issues that were trading at a negative yield to call. “If we see the economy start to turn, we could see some of those negative YTC issues getting refinanced.

“If we see a slight rate hike and they stay [stable] for awhile, we could see more new issues and redemptions [come 2016].”

Continuation of trends eyed

Overall, a lot of the trends seen in 2015 – low $25-par issuance and the move toward fixed-to-floating rate issues in that space, as well as a continued focus on the Fed’s interest rate moves – will continue to play roles in the 2016 market.

“We are finally at a point where things aren’t declining anymore, or as much,” Conery said. “The market is finally coming to the realization that there is going to be an interest rate increase, but there is still so much confusion about Fed policy.”

Until the Fed presents a clear picture on how it will move forward with its interest rate moves, “it’s hard to say [how preferreds will be impacted] because we just don’t know.”

Additionally, signs of inflation – or a lack thereof – along with a depressed commodity price environment and an upcoming presidential election could also factor in to the performance of preferreds in the coming year.

“There’s a lot of things that could change to put pressure on the markets in 2016,” a source commented.

© 2015 Prospect News.
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