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Preferred Securities
As of July 31, 2010
We would like to share with you our review and outlook for the preferred securities market as of July 31, 2010. In the month, the BofA Merrill Lynch Fixed Rate Preferred Index had a total return of +4.2% and the BofA Merrill Lynch REIT Preferred Index returned +3.1%. Year to date, the BofA Merrill Lynch Fixed Rate Preferred Index and the BofA Merrill Lynch REIT Preferred Index had total returns of +9.0% and+10.2%,respectively.
INVESTMENT REVIEW
Preferred securities rallied in July amid a lessening of concerns that restrained the market in the previous two months. Markets were cheered by the ability of Greece, Spain and other European countries to roll over their sovereign debt on somewhat favorable terms. Meanwhile, stress tests released by European regulators gave the market more confidence in the health of Europe’s banks; while some of the headline results were met with some skepticism, investors now had better information with which to conduct their own tests and generally were encouraged.
These developments directly benefited European issuers of preferreds (which account for a meaningful portion of even the U.S. dollar market), while helping financial markets broadly. In addition, the latest recommendations from Basel, a committee representing central banks around the world, were less strict than some had feared with regard to banks’ equity capital requirements, liquidity coverage ratios and date of implementation of certain more costly reforms. The news especially benefited banks in Europe and Japan.
In the United States, a market overhang was removed when financial reform legislation became law. The most extreme components, in terms of what might hurt banks’ profits, were avoided. News of reforms actually worked to the benefit of preferred securities; investors, including those new to preferreds, purchased hybrid securities selling at discounts, with the view that they would be exchanged or purchased at par. To be certain, the phasing out of hybrids (which eventually will no longer qualify as banks’ “Tier 1”regulatory capital) will be a multi-year process. Most banks appear to be in no hurry to surrender this form of capital—which will count 100% as Tier 1 through 2012 and be phased out ratably over the subsequent three years—as they can write off the interest payments, which makes them the cheapest form of Tier 1 available.
Bank earnings were also generally good, another catalyst for good returns from financial preferreds. The return to profitability, first seen at large institutions, has spread to regional banks, some of which reported their first quarterly profit since 2008. Certain large banks in Europe, notably Lloyds Bank and Royal Bank of Scotland similarly reported their first profitable quarters since 2008.Banks in general are showing declines in loan-loss provisioning and bad debt. Because some had reserved for very large losses, they were able to release some reserves. In this environment, certain preferreds issued by banks and brokerage companies had had very substantial rebounds and significantly outperformed the index.
Elsewhere of note, performance in the insurance sector was lifted by European preferreds, as well as Bermuda-based reinsurance companies, which may have been favorably associated with foreign preferreds in the month. Real estate preferreds had gains in a positive period for REIT common shares. Second-quarter earnings reported in July for the most part met expectations, and a few REITs raised guidance. Media, telecommunications and utility issues, good performers in the tougher periods of the early summer, underperformed the index, as news benefited financial companies the most.
INVESTMENT OUTLOOK
We believe the preferred market remainsattractive.Absolute income is high, and yield spreads over corporate bonds and Treasurys are still well above historical averages. In addition, earnings and capital in the banking sector—the most important sector for the preferred market—continue to show marked improvement over past quarters.What is more, over the next several years a sizable portion of the preferred market will likely be refinanced, which will undoubtedly create opportunities.The U.S. hybrid debt bank preferreds are only one form of preferred that is likely to be refinanced, as the Basel Committee on Bank Supervision, an international group of bank regulators, appears to be biased to take away Tier 1 treatment for certain other preferred structures as well.We will learn more about these recommendations and implementation in months to come.
While we remain positively biased, we must note that recent economic indicators have been soft, which could have implications for the preferred market. While we do not foresee a return to recessionary conditions, credit spreads could widen if economic growth appears to continue to lose steam. On the other hand, while a slowing economy could lead to wider risk spreads, demand for income will remain very strong as a result, and Treasury yields will remain exceptionally low. So long as a recession is avoided, this environment should provide a solid bid for preferreds and other high income securities and generally support prices. In the near term we will also follow closely demand for hybrid preferreds as more buyers come into the market in expectation of issuer refinancings. We believe that opportunities in this market are abundant for well-informed investors, but will be more cautious with certain securities that have risen in recent periods due to unusual investor demand.
Past performance is no guarantee of future results.
The performance information in the preceding commentary does not reflect the performance of any Cohen & Steers Fund. Fund performance information is available through the link or links below.
Cohen & Steers Preferred Securities and Income Fund Performance
Please consider the investment objectives, risks, charges and expenses of any Cohen & Steers fund carefully before investing. A prospectus containing this and other information can be viewed by clicking here or may be obtained by calling 800-330-7348. Please read the prospectus carefully before investing. Cohen & Steers open-end funds are distributed by Cohen & Steers Securities, LLC.
The views and opinions in the preceding commentary are as of the date of publication and are subject to change. This material should not be relied upon as investment advice, does not constitute a recommendation to buy or sell a security or other investment and is not intended to predict or depict performance of any investment.
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