By Phil Jacoby, CIO of Spectrum Asset Management (a wholly-owned boutique of Principal Asset Management).
With yields highest and spreads widest since the Global Financial Crisis, now may be an attractive entry point into the preferred and capital securities asset class. Opportunities for upside and higher income potential exist for the asset class now, especially within the contingent convertible (CoCos) subset of the market.
Over the past couple of years, CoCos have increasingly made up more of the preferred and capital securities universe. As of March 31, 2023, CoCos made up 42.4% of the preferred and capital securities market, up from 32.7% as of December 31, 2015 – so the landscape is not what it used to be, and we believe there is uncommon value in CoCos today.
The focus on CoCos
1. Higher income potential
CoCos have been repriced down to previous crisis levels and are currently discounted. This sets the stage for attractive income potential.
2. Historical outperformance, weathering multiple market stress periods
Due to their high level of income, CoCos have performed well since inception of the index on December 31, 2013, compared to Corporate and Treasurys, and we believe they will continue to outperform over the long term despite the current market volatility.
3. Predominate coupon structures can help manage interest rate risk and elevate prices from today’s deep discounts
Fixed-to-floating and fixed-to-variable-rate (also known as fixed-to-fixed reset) are the predominate coupon structures within the CoCos market. As these structures are callable, absent a decline in credit, prices tend to gravitate to par and then either reset at the new coupon structure or are called at par, creating stability in the market and an opportunity for appreciation. We believe the coupons may reset from the 4% area up to within a 7-8% range just a few years from now, elevating prices from today’s deep discounts.
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About the Author:
L. PHILLIP JACOBY, IV – Executive Director and Chief Investment Officer. Mr. Jacoby joined Spectrum in 1995 as a Portfolio Manager and most recently held the position of Managing Director and Senior Portfolio Manager until his appointment as CIO on January 1, 2010, following the planned retirement of his predecessor.
Prior to joining Spectrum, Mr. Jacoby was a Senior Investment Officer at USL Capital Corporation (a subsidiary of Ford Motor Corporation) and co-manager of the preferred stock portfolio of its US Corporate Financing Division for six years. Mr. Jacoby began his career in 1981 with The Northern Trust Company, Chicago and then moved to Los Angeles to join E.F. Hutton & Co. as a Vice President and Institutional Salesman, Generalist Fixed Income Sales through most of the 1980s. Mr. Jacoby holds a BSBA (Finance) from the Boston University Questrom School of BusinessSpectrum Asset Management has had extensive experience managing preferred and capital securities through a variety of challenging market events. We continue to actively manage the assets and are excited about the CoCos sector of the market as they provide an opportunity given the current market environment. We believe that potential investors should take advantage of preferred and capital securities now, given the discounted prices and high yields, potential outperformance in the long term, and various coupon structures that may help migitate any potential losses from a volatile market.
Disclaimers/Notes:
Index descriptions
•ICE BofA Contingent Capital Index tracks the performance of investment grade and below investment grade contingent capital debt publicly issued in the major domestic and Eurobond markets.
•ICE BofA U.S. Corporate Index tracks the performance of U.S. dollar-denominated investment-grade corporate debt publicly issued in the U.S. domestic market.
•ICE BofA Current 10-Year U.S. Treasury Index is a one-security index comprised of the most recently issued 10-year U.S. Treasury note.
Risk considerations
Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal. Fixed-income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Risks of preferred securities differ from risks inherent in other investments. In particular, in a bankruptcy preferred securities are senior to common stock but subordinate to other corporate debt. Contingent Capital Securities carry greater risk compared to other securities in times of credit stress. An issuer or regulator’s decision to write down, write off or convert a CoCo may result in complete loss on an investment.
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