Outlook 2018: Preferred stocks forecast to remain ‘solid’ in new year; bank supply to decline

By Cristal Cody

Tupelo, Miss., Dec. 29 – Preferred stocks are expected to remain solid in 2018 after posting positive returns in 2017 along with equities overall.

The U.S. iShares Preferred Stock ETF returned more than 8% in 2017.

The Wells Fargo Hybrid and Preferred Securities index returned nearly 11% in 2017.

The BofA Merrill Lynch Core Plus Fixed Rate Preferred Securities index was closing out the year with an 11% annual return.

Preferred stocks have a “solid outlook with strong fundamentals, improving technicals and attractive valuations for $1,000 par securities,” Nuveen Asset Management, LLC analysts said in a note.

Equities overall and the high-grade bond market are expected to remain strong in 2018, although not as robust as 2017, following the approval of U.S. tax reform.

“During 2017, U.S. equity markets have delivered exceptional returns,” Morgan Stanley & Co. LLC analysts said in a note. “For 2018, we expect much narrower performance as markets begin to contemplate the peak rate of change on growth and deteriorating financial conditions.

“While it's way too early to call a recession, nor do we see one in 2018; the equity market may start to discount its arrival in the next year. On that note, credit markets may be topping now, which tends to be a good 6-12 month leading indicator for stocks.”

Stocks are expected to outperform bonds for the seventh consecutive year in 2018, a track record not seen since 1928, BofA Merrill Lynch analysts said in a note.

“We forecast 6% EPS growth for the S&P 500 in 2018, or half of the consensus expectation,” the BofA Merrill Lynch analysts said. “We estimate tax reform could initially add up to $19 to S&P 500 EPS (including a potential $3 benefit from repatriation-induced buybacks). While on many measures, S&P 500 valuations appear lofty, stocks are still incredibly inexpensive relative to bonds, both government and corporate, amid low rates and tight spreads.”

Preferreds, which straddle debt and equity, “appear attractive for their high relative yields and their history of lower sensitivity to rising interest rates,” the Nuveen analysts said. “Preferred securities trace back to the 16th century in England and the 1850s in the United States. However, in the 1980s they evolved from a financing tool for highly regulated utilities to an important financing vehicle for financial institutions. Since then, the preferred securities market has experienced significant growth and a change in issuer composition.”

Banks make up about 55% of the market, while insurance companies have a 17.6% stake, industrials have a 13.1% market share, utilities have 6.8% of the market, REITs have 4.9% and diversified financial services have a 2.8% stake, according to market data.

Bank issuance to slow

Bank preferred issuance is expected to continue to decline in 2018.

“U.S. banks have issued a significant amount of preferred securities recently, including $32 billion of gross issuance in 2014, $8 billion in 2015 and $18 billion in 2016,” the Nuveen analysts said. “We expect net new issue supply to continue to decline. U.S. banks are estimated to issue only $5 billion to $8 billion of additional preferred securities between mid-2017 and 2019.”

Still, the preferred banking sector should profit from increased rates, according to the note.

“Banks represent about 55% of the issuer base, and we think the banking sector will benefit from rising interest rates,” the analysts said. “We believe the improvement in credit quality should translate into a lower risk premium (yield spread), resulting in higher prices for preferred securities.”

Multiple structures exist in the preferred securities market, including $25-par senior notes, trust preferreds, traditional preferred stock and Tier 1 securities.

December weakness

Preferreds were ending 2017 stronger but showed weakness in December following the Federal Reserve’s 25 basis point rate hike. The Federal Reserve plans to raise rates three times in 2018.

“Preferred securities suffered as yield spreads widened and the sector posted a negative total return for the week, and significantly underperformed Treasuries,” Tony Rodriguez, co-head of fixed income at Nuveen Asset Management, said in a note.

“The Treasury yield curve has generally flattened throughout 2017, but the trend accelerated in early September,” he said. “The difference between the 30- and 5-year Treasury yields has fallen 50 basis points since Sept. 1. The reduced yield difference reflects the market view that the Fed will continue raising the overnight target rate, pushing short Treasury yields higher.”

New issues mixed

New securities priced in 2017 were mixed in trading as the year closed.

AT&T Inc.’s 5.35% global notes due Nov. 1, 2066 (NYSE: TBB) traded in the $26.28 area the week before Christmas Day.

The Dallas-based telecommunications company sold $1.15 billion of the $25-par notes on Oct. 25.

AT&T was expected to close on its $85.4 billion cash and stock acquisition of Time Warner Inc. at the end of the year. The Justice Department has filed a federal lawsuit to block the deal, and a trial date is set for March 19, 2018.

Annaly Capital Management Inc.’s 6.95% series F fixed-to-floating rate perpetual cumulative redeemable preferred stock (NYSE: NLYPrF) traded up 7 cents to $25.82 in trading on Dec. 21, the last market day before Christmas.

The New York-based real estate investment trust priced an upsized $700 million of the $25-par preferreds on July 25. The deal priced tighter than initial price talk of 7% to 7.125% and was upsized from $200 million.

The dividend is fixed until Sept. 30, 2022 and then will begin floating at Libor plus 499.3 bps.

In other new issue trading, Cowen Inc.’s 7.35% senior notes due Dec. 15, 2027 (Nasdaq: COWNZ) traded up 1 cent, or 0.04%, to $25.32 by mid-December.

The New York-based financial services firm sold $120 million of the $25-par notes on Dec. 5. The amount of the issuance grew to $138 million following the exercise of a greenshoe.

Kimco Realty Corp.’s 5.25% class M cumulative redeemable preferred shares (Baa2/BBB-/BBB-) softened in mid-December to $24.62 in over-the-counter trading under the temporary symbol “KMCCP.”

Kimco, a New Hyde Park, N.Y.-based real estate investment trust, priced $230 million of the $25-par class M cumulative redeemable preferred shares on Dec. 11.

The shares are expected to start trading on the New York Stock Exchange within 30 days of issuance under the permanent ticker symbol “KIMPrM.”

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