"Technical Trifecta" for Selected Preferred Securities: Interview with L. Phillip Jacoby IV, Chief Investment Officer at Spectrum Asset Management

Wall Street Transcript

67 WALL STREET, New York - September 4, 2012 - The Wall Street Transcript has just published its Large-Cap Value and Other Investing Strategies Report offering a timely review for serious investors. This special feature contains expert industry commentary through in-depth interviews with highly experienced Money Managers. The full issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.

Topics covered: Large Cap Investing - Downside Protection - Value Investing - Risk Mitigation

Companies include: Capital One Financial Corp. (COF), Wells Fargo & Company (WFC), National Bank of Greece SA (NBG) and many others.

In the following excerpt from the Large-Cap Value Investing Strategies Report, preferred stock portfolio expert L. Phillip Jacoby IV, Chief Investment Officer at Spectrum Asset Management, discusses the outlook for this asset class for investors:

TWST: As you said, Spectrum focuses on preferred securities. Why did the firm pick that particular area? What makes preferred securities a good place to invest?

Mr. Jacoby: Well, preferreds are rather complicated, which is what we like. We like complexity because it offers an opportunity to implement our program adroitly. Preferreds can be viewed as junior subordinated capital. It is an area of a company's capital structure, which is senior to common equity, but junior to senior debt. Coupons are also allowed to be deferred, so there is an element of not only lower recovery in the event of default, but also a risk that coupons can be deferred without accelerating that default. So there is a two-sided element to the risk aspects of a preferred.

They are very loss absorbent in both respects and are becoming even more loss absorbent as the rules change in the global banking industry in particular. So for that subordination, we seek to get paid a high level of premium. For the most part, a preferred security ought to be the highest-yielding form of capital in an issuer's capital structure. So it's a higher-yielding program based on generally high-quality issuers from an enterprise ratings perspective. In fact, even though many of the issues have below investment grade preferred securities ratings, the company's enterprise ratings are solid investment grade.

TWST: Does that complexity you mentioned scare away some investors?

Mr. Jacoby: Well, I think that it could but I don't think that complexity in and of itself scares the investors more than just the general feel for the macro risk environment that make all risky assets seem somewhat scary at times. So I think those investors who choose not to participate are reacting more to the market as a whole than to the preferred securities space.

TWST: What makes one security more attractive than another?

Mr. Jacoby: Well, it's really about the yield and the structural risk you have to accept in order to earn the yield. There are also elements of a story in the preferred market, much like when one purchases a common equity, they purchase a story. And with preferreds there is a story to the sector, and that is encompassed in three different areas that we refer to in general as a "technical trifecta."

There are a number of changes underway in banking regulation, which are impacting U.S. bank trust preferreds, and also in global bank regulation, which are impacting non-U.S. preference shares and hybrids issued by the foreign banks. Basically, what is happening is that the existing structures of preferred are effectively being phased out of net core capital. We identified this trend about two years ago now, and it seems to be playing out as expected so far, which is a good thing for investors and it still has some room to run.

As a result, what were typically long-dated issues, or perpetual issues, are becoming de facto

intermediate issues by regulatory choice or design. Effectively, what used to be core capital of the banks will no longer be core capital as we move through these phase-in periods through 2022. So banks that used to earn an equity credit, a regulatory equity credit, for a certain preferreds will no longer be allowed that equity credit, and as a result banks will have to pay something for nothing, and no one ever would like to do that.

Consequently, there should be a gradual, but sometimes lumpy, redemption cycle of a very significant portion of the preferred market, namely the banking sector. In the U.S., the redemption cycle has started in the trust preferred market due to the Dodd-Frank bill, and the replacement capital is plain vanilla, noncumulative preferred stock. In the foreign sector, the new Basel III rules on capital should accelerate a similar redemption cycle in three to four years. So those are the first two elements of the "technical trifecta."

And the third element is what we refer to as the "rating agency equity credit knockdowns," and this is a very unique change, because back in the mid-2000s rating agencies allowed preferreds to be issued with various equity-like features, such as replacement capital covenants, longer maturities of, shall we say, 50 years or 60 years rather than 30 years, and extended coupon deferral options. Rating agencies would then view these features as having equity-like features, and as a result nonbank issuers, nonregulated issuers such as industrials and a whole host of insurance companies issued a lot of enhanced equity capital securities and got a 75% equity credit as tax deductible debt, effectively. A lot of these so-called enhanced equity capital securities were issued in the mid-2000s, 2005, 2006 and 2007 as very tax-efficient and very cheap equity for these issuers.

But when the financial crisis played through, the rating agencies changed their minds on the allowance of these features of having equity credit, which was a rude awakening for issuers. Basically what happened was that the issuers had expected a 10-year benefit on the equity credit, but they only got about four years worth since the rating agencies took back 50% of the credit.

So as a result, the issuers were left with more expensive debt than they had initially intended rather than inexpensive equity. Consequently, these issuers should be looking to retire this expensive debt at the first call dates, which are coming up mostly in 2016 and 2017.

All told, there are some very unique aspects to the preferred securities market that can foster a story in addition to the sector having the yield supplemented by being subordinated capital. It can be really complex, but at the same time it can be quite compelling on a relative yield basis compared to other asset classes. All these complexities make active management a better way to sleep at night with preferreds rather than passive management, which can lead to some night sweats from mispricings and exposure to big concentrations that can be called away, which only leads to rather material reinvestment risk.

TWST: You talked about some of the regulatory changes and other factors that are positives. Are there issues floating around out there that may negatively impact the space?

For more from this interview and many others, visit the Wall Street Transcript - a unique service for investors and industry researchers - providing fresh commentary and insight through verbatim interviews with CEOs and research analysts. This special issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.

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