Preferred securities catching institutional interest, says US fund house

Principal Global Investors says it is seeing renewed interest among wealthy and institutional investors in Asia for its preferred securities fund, with market opportunities created by post-crisis changes to regulation and rating agencies.

The Ireland-domiciled Ucits fund for non US taxpayers is sub-advised and actively managed by Spectrum Asset Management, a 25-year-old US-based boutique with $13.5 billion in AUM that was acquired by Principal Global Investors in 2001.

According to a company statement, the hybrid securities fund which was established in 2003 has just surpassed $600 million in assets, with growth having accelerated especially in the past year.

While it is understood the majority of interest is coming from European investors, Andrea Muller, Asia chief executive of Principal Global Investors, suggests it is also gaining traction among institutional investors and via private bank distributors in Hong Kong and Singapore, as well as in Japan and Australia.

She was unable to provide a figure on the Asia AUM breakdown. She says the fund is being distributed by the Singapore and Hong Kong offices of a US brokerage firm's private wealth division as well as several Swiss private banks. A quick call to UBS Wealth Management confirmed that it is not distributing this fund.

“Investors are looking for yield, and this instrument has lower correlation to other asset classes,” she says. “We are seeing tremendous interest among the high-net-worth segment and from institutional investors in countries such as Korea, Taiwan and Thailand.

“Preferred securities are less well known in Asia, where this is relatively new. For some it requires additional education, because there are not many Asian issuers of preferred securities.”

She estimates that its Ucits fund contains over 200 preferred securities, 59% of which were issued in the US, 34% in Europe and 6% elsewhere. Year-to-date the cumulative performance of the fund stands at 7.5%, while three- and five-year annualised returns are 29% and 3.6%, respectively.

Preferred securities are fixed income products mainly issued by banks and insurers that sit between senior debt and common stock. They are long-dated, from 30 years to perpetual, with a coupon that is deferrable, for example in the event of a bankruptcy.

This forms part of the product risk, although Muller notes that these products have a significantly lower default rate compared with high-yield bonds.

Essentially they evolved in the US in particular as a way for banks to bolster their capital. And Muller suggests that these products have seen increasing interest on the back of changes in regulation (Dodd-Frank and Basel III) and rating agencies.

“Dodd-Frank said trust preferred securities used as bank capital would be grandfathered through 2012 and then phased out as tier-1 capital beginning in 2013,” she notes. “Basel III said hybrid preferred securities would be grandfathered through 2012 and then phased out as tier-1 capital over the next 10 years.

“Meanwhile, rating agencies changed the way they analyse hybrid preferred securities after the financial crisis to give issuers reduced equity credit treatment.

“What the regulators were trying to do was reduce the risk of failure and insolvency in banks, but the unintended consequences of this was that some are going to be called earlier than they would otherwise have been.

“So instead of yield to maturity, investors should consider something like yield to legislative maturity, meaning time-horizons are going to be shorter. This results in reduced credit risk, reduced interest rate sensitivity and reduced price volatility.

“We expect preferred securities, with their long-horizon yields, to assimilate the lower volatility, credit risk and duration of much shorter-term instruments, presenting investors with a unique investment option.”

Muller says other types of securities are being issued in place of those being phased out, adding the ultimate impact may not be market shrinkage, but re-composition. “All these regulatory changes are unique to the preferred securities market and this is creating opportunities.”