Strategies For Investing In Preferred Securities
L. Phillip Jacoby, Iv
TWST: Please begin with a brief introduction to Spectrum Asset Management, including some highlights from your history and your current assets under management.
Mr. Jacoby: Spectrum Asset Management has been around for a number of years. It was founded in 1987 and was acquired by Principal Global Investors in 2001. We're headquartered in Stamford, Conn., and we have a little more than $11 billion in assets under management. We are an SEC-registered investment adviser, also a registered broker-dealer and a member of FINRA. We have institutional mandates, separately managed accounts, open funds distributed here and globally through Principal Global Investors and we also subadvise for Nuveen Investments on six closed-end funds traded on the New York Stock Exchange. We've been involved in the preferred market from our inception. It's a specialty market, and it's one that has helped the firm focus and grow. Preferred securities are what we do, it's all we do and we have indeed been doing it for years.
TWST: How would you describe your investment philosophy?
Mr. Jacoby: As I said, we do have a specialty focus on preferred securities, and our philosophy is one of diversification in the hybrid preferred market and preferred stock market among 100 or so different kinds of issuers and structures, primarily in the banking, insurance, utilities and REIT space. So the philosophy itself is a down-in-cap structure philosophy, where we look to get paid for the subordination that's inherent in the preferred security. Preferred securities are senior to common equity, but junior to senior debt, so it's somewhat of a mezzanine play, if you will, in the capital structure, where we are not only subordinate in ranking, but also accept a preferred's ability to differ coupons. We look to get paid a fair amount of incremental risk premium over senior debt in order to accept that risk. So the philosophy overall is that it's primarily income-oriented and diversified.
TWST: Broadly speaking, why is now a good time to be invested in preferred stocks?
Mr. Jacoby: We certainly have come through quite a time in the financial crisis, and the industry of financials overall has changed and improved quite dramatically. There are a number of very meaningful and significant regulatory changes underway in the financials, not just here in the United States, but also globally. The Dodd-Frank Act that was signed into law last July as a broad overhaul of financial services - it is effectively changing the product life cycle of U.S. bank trust preferred. I can go into a little bit later. There is also reform in international banking, of course the U.S. is included in that, but these rules come through what's known as The Basel Committee on Banking. This committee is changing the scope of the capital stack for financial institutions in an effort to forestall any further financial instability such as we've seen over the past couple of years. The major effort behind the Basel Committee is to prevent taxpayer-funded bailouts from ever happening again. In order to help that along, the rules will be changing the entry criteria for preferreds, so they can absorb more losses. The mandate also calls for more equity capital to support these institutions, which itself is a fundamental positive for the credit of a financial institutions.
In addition to these, there are rules that are changing from the rating agencies. They have decided to alter the way they look at certain hybrid preferreds and have taken back some of the equity credits allowed to these structures when they were issued a few years ago. As a result, these equity-enhanced structures have changed from being inexpensive equity to expensive debt. This is what we refer to as a rating agency equity credit knockdown. It sounds like a bad thing; however, it's a good thing for the investor because it offers a very unique technical feature that's compelling some issuers to tender for paper in advance of the call dates. As a result, there is a magnetic pull to par that is reducing the volatility of the sector. So these three things, in addition to the general overall credit improvement that we've seen, and expect to continue, bring some extraordinary and very unusual technical drivers to the hybrid preferred market. Effectively what's happening is that you've got a technical trifecta, where you have regulatory rules for preferreds changing on two fronts and the third element coming from the rating agencies, where the net effect is to incentivize certain structures of preferreds to be retired from capital.
The Dodd-Frank Act requires that big U.S. banks no longer issue trust preferred securities, and that these trust preferred securities will be eliminated from capital beginning in 2013, then gradually phased out over a period of three years. So by the end of that phase-out period in 2015, there will no longer be trust preferred allowed in bank capital. As a result, we expect banks to actively call in their trust preferred once this legislated phase-in period begins in a few years. But even though the overall horizons for trust preferreds at U.S. banks have been meaningfully reduced as a result of that, there are nice yield opportunities available in a, let's say, two- to four-year range. These are effectively 30-year-type yields, but that will more than likely have terms of only two to four years. So the volatility should be markedly reduced while the income and yield are still quite compelling. The same horizon effect is going on with The Basel Committee rules on banking, as it changes the entry criteria for hybrid preferred securities. As a result, these too will be phasing out certain innovative structures and noninnovative structures of preferred from bank capital.
Basel III is mainly a foreign bank phenomenon. So here, too, there will be a phase-out period that begins in 2013 and could continue all the way through 2022. Technically, certain types of preferreds are going to be removed from bank capital, which means that if the banks leave them outstanding, then they will be paying something for nothing, which doesn't make much sense. So this shortens the expected term horizon on the foreign sector. The other part of this trifecta which comes from the rating agency equity credit reductions is mostly non-bank. Rating agencies effectively allowed certain types of enhanced hybrid preferreds to be credited with a significant amount of equity, sometimes equity credits, and as much as 75%. So in 2005, 2006 and 2007, there were a number of non-banking institutions, mainly insurance companies, that decided to issue hybrids due to this new and generous equity credit allowed by Moody's and S&P. The issuers were able to get a tax deduction for subordinated debt while at the same time getting a kiss from the rating agencies for equity. It was a very cheap date. But then come July, Moody's changed the rules and significantly reduced these equity credits, which made date night more expensive. Instantly, paper that was issued with 75% equity had as little as 25% equity. This was a pretty meaningful take away from the issuers and, as a result, some have tendered for their securities. These tenders have been rather rewarding for investors.
Progressive Insurance (PGR), for example, tendered early on for its enhanced hybrid issue up about 5% from its pre-tender price. A 5% move for a fixed income investor is very attractive tailwind. More recently, Travelers (TRV) tendered and even some bank issuers are tendered for some of their hybrid preferred to remove capital replacement covenants. So many of these non-bank securities have call turns left until 2016 and 2017, and it is very likely, in our opinion, that they will end up ultimately calling them away at that time. So here, too, is another example of 30-year-type yields with an intermediate-type horizon. When compared with intermediate U.S. treasuries, these horizon yields can pick up 500 basis points or more in yield, which is far better than plain-vanilla bullet bonds. Overall, preferred yields are quite compelling and have a technical story of meaningfully reduced volatility expectations in a generally investment grade market.
TWST: You use a combination of bottom-up and top-down investment strategies. Would you actually walk us through your process of choosing holdings and tell us a little bit about what you believe makes your strategy unique?
Mr. Jacoby: We focus top down, from the industry on down to companies that are leaders in their spaces. These are names that we've all heard about before, Bank of America (BAC), AEGON (AEG) and ING (ING), Wells Fargo (WFC) the list goes on and on. So in that context, we begin by looking in-depth through the credits, and we will assign certain percentages that we would like to own in individual names in an effort to diversify the strategy across 60 to 80 different names in a portfolio. But within each name, there can be a number of structures to buy and structures to avoid. Broadly speaking, the hybrid preferred market is divided into two very distinct sectors. One sector is the $25 par sector, which is New York Stock Exchange traded. The other sector is the capital securities sector, which is $1,000 par, and it trades with accrued interest just like a bond does. The $25 par sector is largely a retail sector, people like you and me who look to this sector to purchase preferreds on the New York Stock Exchange just as we would a common stock. So the $25 par sector has very uniquely different behavioral attributes compared with the capital securities sector.
The capital securities sector is an institutional sector. It's the same product overall, but it's just packaged differently for a different subset of ultimate investors. In the capital securities' case, it's the institutional investor; in the $25 par case, it's the retail investor. So oftentimes we find that while one sector zigging, the other sector is zagging, but that's in the short term. That might be a month-to-month phenomenon, where there is some technical drive going on in one sector that is not going on in the other sector. Institutions tend to be very cognizant of what's happening to interest rates in the treasury market, so a capital security in normal times would behave more in lockstep with a Treasury bond and interest rate changes, for example. Yet, retail might not necessarily care as much about what's happening day-to-day, but would certainly be cognizant of what's happening in the longer term.
So both sectors do indeed have fixed income-trading attributes that characterize them over the long term, but the two can be very unique and different in the near term. The capital security sector can be very complicated from a structural perspective, while the $25 par sector is reasonably plain vanilla. The $25s are typically 30-year or even perpetual in nature with five-year call options. Capital securities, on the other hand, can be 30-year, they can be 10-year, they can be dated, they can be perpetual and they can have some very unique features that could cause them to behave differently. It is these structural details that we pay very close attention to from the bottom up.
TWST: You mentioned that you focus on the banking and insurance sectors. Are there any other sectors that make up a significant portion of your holdings?
Mr. Jacoby: Yes, primarily banking or financials. We are more concentrated in financials, which include banking U.S., banking non-U.S., insurance, which will include reinsurance, property and casualty, and life insurance companies. Other industry sectors include real estate investment trusts, utilities and even some industrials.
TWST: What are some holdings that are representative of your investment philosophy and strategy?
Mr. Jacoby: ING, Barclays Bank (BCS), Bank of America, AEGON, Deutsche Bank (DB), Citigroup (C), Santander (STD), BBVA (BBVA), Prudential (PRU), RenaissanceRe (RNR), MetLife (MET), Wells Fargo, Public Storage (PSA), Regency Centers (REG), ProLogis (PLD), CBS (CBS), Burlington Northern (BNI).
TWST: What are the key risks to investing in the preferred market and what is your risk management strategy?
Mr. Jacoby: Risks are primarily credit, as you would expect with any credit product. So we do pay very close attention to following credit and taking the right names that we feel have the ability to pay as agreed. There is certainly some ratings risk, such as what we went through during the financial crisis. A lot of that risk has also been somewhat technical, because the rating agencies are changing their ratings methodologies for preferred securities. The credit review process is something that we pay very, very close attention to for our security selection. The strategy overall is very diverse. We prefer to minimize investors' risk by spreading out the concentrations rather than making big individual bets, no matter how much we may love a story.
Aside from that, there certainly is some interest rate risk. So to the extent that long interest rates were to go materially higher, you very well could see a potential for preferred securities prices to go down in sympathy with a declining long bond price or a declining 10-year price. But that being said, the trifecta elements that we discussed earlier actually can lead to a pretty significant cushion opportunity or cushioned element to the sector, which is very unique and different from the way some preferred have behaved in the past. There is also some product life-cycle risk as well. Just by virtue of the trifecta being an intermediate-term investment advantage, there is also some longer-term risk to the extent you wanted to stay reinvested in preferred securities.
Now the product life cycle is going to be changing. We've had quite a period of growth; in fact, preferreds and hybrid preferreds have seen these life cycle challenges before, so this is not the first time. We had very meaningful amount of innovation back in 1996 when the U.S. Federal Reserve allowed trust preferred to be included in Tier 1 capital. At that point, innovation created quite a growth curve from 1998 all the way through 2000 with the advent of many step-up preferreds being done from foreign institutions, which carried the growth through 2006; and then the enhanced equity capital securities, which overlapped and pushed the growth phase into 2007. So we've had a lot of growth through 2007 and then an effective maturity stage up through 2009. And now we've entered into a period of decline for the hybrid product from an issuance perspective, but the decline will likely last well into 2017 and even beyond that. However, in this midst of this decline, this being a decline in the existing hybrid preferred product, there is a lot of opportunity for hybrid innovation to start all over again. And that's what we're beginning to see right now with the changes in capital rules.
It's likely that we will see many U.S. banks issue forms of preferred capital again that had already been issued in the past; for example, noncumulative perpetual preferred stock, which is very different from the hybrid preferred; and also REIT, real estate investment trust, preferred, which effectively packages the mortgages of big banks into a funding subsidiary that they use for tax efficiency to raise Tier 1 capital. That's a product we've seen in the past and one we are likely to see again in the future. There is also the prospect of contingent capital, which has been very topical with the investor community and certainly with the Basel III initiatives. Basel in fact is actively encouraging innovation through contingent capital, which would actively be a form of noncommon Tier 1 that would count as core capital, but would turn into equity capital upon some trigger event. The idea here is that contingent capital would be immediately nondilutive, in some cases tax efficient, and would bolster the bank's core capital and help to forestall systemic risk.
So a lot of very exciting innovative changes are underway, so as we complete the life cycle of the existing product, there is quite a bit of excitement and thought going into the innovation for what will become another preferred securities life cycle starting all over again going forward.
TWST: How would you describe the investor who is the ideal match for Spectrum Asset Management?
Mr. Jacoby: I think that would be an investor who would be looking for lower volatility right out in front of us, probably the next three to four years, an investor who prefers to patiently earn income and build capital through the power of compounding income reinvestment. The Rule of 70 says 7% in 10 years can double your money. It's an investor who wants to have a well-diversified portfolio in well-known companies. This would be a portfolio that can earn income above what would typically be earned on senior debt. For the retail investor in particular, there can be a tax advantage to qualified dividend income and perhaps a reasonably tax-efficient haven from municipal bond risk. So that could be any number of retail investors around the globe and any number of institutional investors, insurance companies and endowments, for example.
TWST: Thank you. (MES) L. Phillip Jacoby, IV
Executive Director & Chief Investment Officer
Spectrum Asset Management, Inc.
Two High Ridge Park
Stamford, CT 06905
(203) 968-1455 - fax