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Preferred Market Update

March 16, 2020

A selloff in preferred and contingent capital securities, alongside corporate and high-yield bonds, accelerated last week as coronavirus fears intensified. Rising cases of Covid-19 outside China, lockdowns in Italy, Spain and France, a patchwork of federal and state government responses, and limited availability of coronavirus testing in the United States gave investors plenty to worry about.

We are not epidemiologists and cannot opine on the particular course of the current coronavirus pandemic, although a sharp decline in new Covid-19 cases in China suggests strong efforts to limit transmission can be effective. As investors in long-term (often perpetual) securities, we have always taken a long view on the economy, credit quality and an issuer’s ability to meet its obligations. From that perspective, we remain confident in the preferred market in general and our investments in particular. We outline our reasoning below.

First, monetary policy has eased and is likely to continue to do so. Central banks globally have cut rates and, more importantly, are providing liquidity to their banking systems. We will focus on the US, but many foreign central banks have taken similar steps as well.

These are broad and substantive actions by the Fed and other central banks. The Fed’s provision of liquidity and lowering of constraints on banks to deploying that liquidity are particularly important. As governments, businesses and individuals seek to slow the spread of this virus, the economy’s demand side (e.g., reduced travel & entertainment spending, deferral of investment spending) and supply side (e.g., reduced work hours and business closures, supply chain disruptions) will come under downward pressure. If measures to slow viral transmission are successful, reductions in economic activity should be temporary, but they could be sharp. US inflation-adjusted gross domestic product (real GDP) is almost certain to be negative in the second quarter. Businesses will need working capital and an ability to refinance maturing debt during this period, so it’s critical for the banking system to be able to supply that credit. Similarly, individuals may see work hours curtailed and face strains meeting debt obligations; they will need forbearance. Banks in the US are exceptionally well-positioned to do that, with strong levels of capital and large loan-loss reserves. And the Fed is ensuring that banks have ample liquidity to meet demand for credit. This is how monetary policy prevents a serious but inherently short-term disruption from becoming a long-term downturn – and the Fed is getting ahead of this problem. We think it’s highly unlikely that Covid-19 precipitates a financial crisis in the United States.

Second, the US economy comes into this situation in good shape. Real GDP growth was 2.3% last year, and the Atlanta Fed’s most recent “nowcast” for first-quarter GDP is 3.1% (updated 3/6/2020 reflecting data mostly from January and February). Of course, economic activity likely slowed significantly in March and probably will be even worse in April. However, the US economy faces coronavirus shocks from a position of strength, and monetary policy and, increasingly, fiscal policy should help soften the blow.[3]

Turning now to markets, as the Fed cut rates to near zero, Treasury yields fell sharply. The 10-year Treasury today yields about 0.7% compared to 1.6% in mid-February before coronavirus concerns began to intensify and 1.9% at the end of 2019. After its latest move, Fed Chairman Powell commented that the FOMC would be “patient” in raising the funds rate. We expect rates will remain exceptionally low until a coronavirus vaccine has been developed and administered widely, which health officials expect will take at least 12 months. Accordingly, short-term rates should stay low for the next year or more, though intermediate and long-term rates could move up as progress fighting the virus is achieved.

Figure 1: Financial conditions have tightened; Fed pushing back aggressively

Credit spreads widened dramatically as Treasury rates fell and credit worries intensified. Wider credit spreads and lower stock markets contributed to sharply tighter financial conditions (Figure 1), which the Fed is addressing as discussed above. Among sectors that are important issuers of preferred securities, fundamental credit quality remains solid overall (see our latest Economic Update from February). Energy producers are likely to face major challenges from sharply lower oil and gas prices, but pipeline and midstream companies – which comprise all of our energy investments – have significantly less commodity price exposure than producers and should weather this period of lower energy prices. In contrast, bank balance sheets have rarely looked better. In just one illustration of the health of the US banking system, problem loans are at or near historical lows (Figure 2). We believe banks are well prepared to handle strains from the coronavirus.

Figure 2: Banks’ problem loans hovering at or near historical lows

Prices of nearly all preferred and contingent capital securities are down materially, led by energy names but even among the strongest bank issuers. Nonetheless, we remain confident in the long-term credit quality of issuers in the portfolio. Many companies will see earnings fall, but we expect their ability to pay interest and dividends to remain intact. Risk premiums have jumped well ahead of likely risk, and we see good opportunity for investors willing to ride out this period of uncertainty. We probably need to see new coronavirus cases slow meaningfully before credit markets can stage a substantial rebound. While much depends on how long the shock from coronavirus lasts, as long as firms have available liquidity – and we think the Fed’s support of the banking system will ensure that – then credit spreads could narrow swiftly when market sentiment improves. From current levels, there is a lot of upside in that recovery.

Flaherty & Crumrine Incorporated

© 2020, Flaherty & Crumrine Incorporated. All rights reserved. This commentary contains forward-looking statements. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast; the opinions stated here are subject to change at any time and are the opinion of Flaherty & Crumrine Incorporated. Further, this document is for personal use only and is not intended to be investment advice. Any copying, republication or redistribution in whole or in part is expressly prohibited without written prior consent. The information contained herein has been obtained from sources believed to be reliable, but Flaherty & Crumrine Incorporated does not represent or warrant that it is accurate or complete. The views expressed herein are those of Flaherty & Crumrine Incorporated and are subject to change without notice. The securities or financial instruments discussed in this report may not be suitable for all investors. No offer or solicitation to buy or sell securities is being made by Flaherty & Crumrine Incorporated.

[1] Normally, we would view a lower capital buffer as a possible credit concern. In these circumstances, we think it helps prevent a temporary liquidity shortage from triggering a fundamental credit downturn. It’s good policy.

[2] The eight US G-SIBs are JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Bank of New York Mellon, State Street, Goldman Sachs, and Morgan Stanley.

[3] As of this writing, US fiscal policy actions have been limited in size and scope. We await additional policy responses from Congress and the Administration as the situation evolves.

Destra Capital Investments is providing this update with permission from Flaherty & Crumrine Incorporated. No offer or solicitation to buy or sell securities is being made by Destra Capital Investments.