After falling out of favour following the financial crisis, the preferred securities market came to life to outperform all sub-classes within the fixed income universe in 2017. 
Preferred securities climbed almost 10 per cent over the year, outperforming the 7 per cent return for (US or global) high yield – the next top-performing segment of bond markets. A number of factors fuelled the outperformance for preferred securities last year – many of which are still in place for 2018.
Accelerating growth boosting preferred securities outlook
In a yield constrained market, investors can expect yields of 5 per cent or more from preferred securities. Despite being almost-exclusively issued by investment grade businesses, preferred securities offer yields far in excess of what is obtainable in the traditional investment grade credit market.
While sitting lower down in the capital structure of these businesses, we see minimal default risk for issuers of preferred securities – particularly with growth accelerating across the world.
The appeal of this segment of the fixed income market relative to high yield debt has also moved significantly in favour of preferred securities.
Historically, high yield instruments – which are usually a number of notches lower in terms of credit quality – have offered a yield pick-up of about 230bps over preferred securities, but this has fallen to just 70 basis points in the global clamour for yield.
Many of the largest issuers of preferred securities come from the financial sector, such as banks and insurance companies. Bank-issued ‘CoCos’, or contingent convertible notes, led returns for the preferred securities market in 2017.
Accelerating global growth, as well as the expected rising interest rate environment, provides additional benefits to financial companies – further brightening the outlook for CoCos this year.
Active management essential in preferred securities
Despite the strong year in 2017, the supply and demand dynamic for preferred securities remains strong – with many parts of the preferred securities market remaining significantly underserved by limited new issuance.
However, not all preferred securities are made equal. The market is split into two categories – institutional (or over-the-counter) and retail, making up 80 per cent and 20 per cent of the overall market respectively.
The retail market for preferred securities is under pressure. A third of the market is either callable or soon-to-be callable at par. With many securities trading at a 6-8 per cent premium this is likely to result in a short-term loss from current valuations.
ETFs now make up 15 per cent of the retail market and as forced buyers of the broad retail market, it will leave investors in ETFs exposed to any losses.
Similar to other inefficient markets, preferred securities uniquely benefit from active security selection. Active portfolio managers can access both the institutional and retail markets, therefore avoiding the pitfalls of being forced buyers in the rapidly-evolving retail market.
Brian Cordes is portfolio specialist at Cohen & Steers. The views expressed above are his own and should not be taken as investment advice.