September 2018 Fixed income perspective: preferred securities In today’s environment of relatively low Douglas Baker, CFA interest rates and rising volatility, preferred Portfolio Manager securities appear attractive for their historically Nuveen Asset Management, LLC high relative yields and their history of lower sensitivity to rising interest rates. They also may help diversify a fixed income portfolio due to their historically low correlation to Brenda Langenfeld, CFA other bond and stock asset classes. We believe Portfolio Manager preferred securities offer many additional Nuveen Asset Management, LLC benefits, including: • Tax-advantaged income potential, since many preferred security structures pay qualified Preferred securities have offered dividend income (QDI) higher income potential compared to • Reduced interest rate sensitivity through fixed- other fixed income sectors. Primarily to-floating rate coupon structures investment grade securities, their low correlation to other fixed income sectors • Predominantly investment grade securities to help manage credit risk and equities may also strengthen portfolio construction in an uncertain • Inherent market structure inefficiencies environment. We find preferred that may create alpha opportunities for active managers securities attractive today from fundamental, technical and valuation • Solid outlook with historically strong perspectives. Market inefficiencies may fundamentals, improving technicals and also provide opportunities to add alpha attractive valuations for $1000 par securities to fixed income portfolios, and certain structures may have tax advantages. NOT FDIC INSURED | MAY LOSE VALUE | NO BANK GUARANTEE Fixed income perspective: preferred securities WHAT IS A PREFERRED SECURITY? Financial institutions now make up most of the preferred universe. Since 2008, banks and Preferred securities don’t fit neatly into an asset brokerage firms (domestic and international) allocation category, as they contain features have issued preferreds en masse to replenish of both stocks and bonds. A preferred security capital depleted by housing and subprime losses can be classified as either debt or equity on during the financial crisis. the balance sheet, depending on its features. The easiest way to identify preferred securities is by their placement within the corporate Exhibit 2: Financial institutions dominate the capital structure. market Exhibit 1 illustrates how preferreds typically Banks 52.8% reside on the boundary between debt and Insurance companies 19.3% equity. In a bankruptcy or liquidation, preferred Industrials 12.9% security owners have a higher priority than Utilities 7.2% common stock owners, but a lower priority than REITs 4.6% senior debt holders. They will be paid only if Diversified financial services 3.2% there is money left after senior creditors have been made whole. Data source: BofA Merrill Lynch, Bloomberg L.P., 30 Jun 2018. Based on the ICE BofA Merrill Lynch U.S. Exhibit 1: Preferred securities straddle debt All Capital Securities Index. and equity Class Seniority Secured debt TYPES OF PREFERRED SECURITIES Unsecured debt Debt A preferred security’s combination of features Unsecured subordinate debt will classify it as either an equity or a fixed Hybrid securities & tier 2 securities income security, but most preferred securities Preferred stocks & have elements of each. For example, some Equity additional tier 1 securities preferred securities generate income in the form Common stocks of interest while others generate income in the form of dividends. Other common features are Source: Standard & Poor’s. shown in Exhibit 3. Preferred securities trace back to the 16th century in England and the 1850s in the United POTENTIAL BENEFITS OF PREFERRED States. However, in the 1980s they evolved from SECURITIES a financing tool for highly regulated utilities to an important financing vehicle for financial Preferred securities potentially offer relatively institutions.1 Since then, the preferred securities attractive yields, especially in today’s lower market has experienced significant growth and a rate environment. They may also provide less change in issuer composition. sensitivity to interest rate changes, portfolio diversification and tax-advantaged income. This combination has created significant interest in the asset class. A preferred security can be classified as either debt or equity on the balance sheet. 2 Fixed income perspective: preferred securities Exhibit 3 – Multiple structures exist in the preferred market Traditional Feature Senior notes Trust preferred Hybrids preferred stock Common stock Character Debt Debt Debt Equity Equity Senior to hybrids, Senior to trust Senior to all equity; preferred and Junior to all preferred, hybrids, junior to senior debt, Junior to debt Priority of claims common equity; debt; senior to preferreds and subordinated debt and preferred junior to senior and common equity common equity and trust preferreds subordinate debt Nature of payment Interest Interest Interest Dividend Dividend U.S. Tax advantage None Typically none Typically none DRD 2/QDI 3 DRD 2/ QDI 3 Typically Typically Term Dated Typically perpetual Perpetual 30 – 40 years 30 – 60 years Payment Yes, typically Yes, typically Yes, typically None Yes, indefinite deferral option 5 – 10 years up to 10 years indefinite Cumulative/ Typically Typically Mostly N/A Noncumulative noncumulative cumulative cumulative noncumulative Sources: Preferred Securities Quarterly Guide, BofA Merrill Lynch, 2 Feb 2018; Nuveen Asset Management. Attractive relative yields yield. Since preferred securities are hybrids of stocks and bonds, certain preferred securities Because they are lower in the capital structure generate qualified dividend income. This type and thus carry more subordination risk, of income is typically created by common preferred securities generally contain wider stocks and taxed at the lower capital gains credit spreads and pay a higher level of income tax rate. In contrast, traditional fixed income than their more senior debt counterparts. As investments create income subject to ordinary shown in Exhibit 4, preferred securities have had income tax rates. attractive yields relative to other asset classes. They have offered more income-generating A high quality investment power than equities and most fixed income asset classes, with the exception of high yield bonds. Preferred securities are generally issued by high quality companies. Due to their subordinate Exhibit 4: Preferred securities have offered capital structure position, preferreds may be attractive yields (%) rated 3 to 5 quality notches lower than the senior debt of the same issuer. For instance, an entity 4.06 4.02 issuing a preferred security rated BB would 3.29 2.84 typically have investment grade senior unsecured 1.81 1.93 debt rated BBB or higher. Although preferred securities are lower in the capital structure than traditional bonds, many are investment grade Preferred Broad bond Intermediate- Intermediate- U.S. Cash securities market term term corporate equities in nature. They may produce a higher yield Treasuries bonds than investment grade corporate bonds without Data source: BofA Merrill Lynch; Bloomberg L.P., www.treasury.gov, 30 Jun 2018. Past performance the credit risk of a below-investment-grade, does not guarantee future results. Representative indexes: Preferred securities: ICE BofA Merrill Lynch U.S. All Capital Securities Index; Broad bond market: Bloomberg Barclays U.S. Aggregate Index; high yield bond. Intermediate-term Treasuries: Bloomberg Barclays U.S. Treasury 7-10 Year Index; Intermediate- term corporates: Bloomberg Barclays U.S. Corporate Investment Grade Intermediate Index; U.S. Exhibit 5 shows how the quality of the Equities: S&P 500 Index; Cash: 3-Month T-Bill Yield. Investors cannot invest in an index. company issuing the preferred securities is typically much higher than the rating of the Tax-advantaged income potential individual securities. For example, 31% of Beyond an attractive yield, a majority of individual preferred securities are rated BB preferred securities pay qualified dividend but only 3% of companies issuing preferred income (QDI), which may enhance after-tax securities are BB rated. 3 Fixed income perspective: preferred securities Exhibit 5: Preferreds are predominantly rated Less sensitivity to rising interest rates investment grade from high quality issuers (%) With interest rates at moderately low levels, Preferred securities, security level Preferred securities, issuer level many investors continue to be concerned about the potential impact of rising rates. Indeed, when 63 60 interest rates go up, bond prices go down, but different types of bonds have varying sensitivities to changes in interest rates. 31 21 The higher average coupon rate of preferred 13 7 securities can help offset the negative price 3 2 0 0 0 0 impact of rising rates. And preferred securities AAA AA A BBB BB B are often more sensitive to changes in credit Data source: Bloomberg L.P., BofA Merrill Lynch and Nuveen Asset Management, 30 Jun 2018. Past spreads than other types of bonds. On a relative performance does not guarantee future results. Breakdown of the credit quality of the constituent basis they may perform well during periods of components of each of the indexes being compared. Preferred Securities represented by the ICE BofA Merrill Lynch U.S. All Capital Securities Index; Security Level ratings based on the highest ranking gradually increasing interest