This article was first published to Systematic Income subscribers and free trials on May 2.
The very sharp rise in interest rates in recent months has not escaped the notice of the vast majority of income investors. More persistent inflation than initially expected pushed the Fed in a more hawkish direction. And while some investors expect the Fed to make a soft landing, the reality is that 11 of the 14 cycles of tightening in the US after World War II were followed by a recession within 2 years.
In this article, we look at a number of high-quality income stocks that are expected to outperform in the next recession. Our base case is that Treasury yields fall while credit spreads widen. In this scenario, higher quality, longer duration securities should outperform the broader income market.
Longer lasting assets look better now
In our view, there are several reasons why higher quality, longer duration assets are ultimately attractive.
First, nominal 10-year Treasury yields are not far from their decade highs after a rapid recovery from the COVID crash.
Second, real 10-year Treasury yields have moved closer to zero from very depressed levels. Real yields measure the level of nominal Treasury yields above inflation expectations. A level close to zero means that nominal 10-year Treasury yields are in line with current inflation expectations over the same forecast period. And while a figure well above zero would be more attractive, at least Treasury yields no longer lag inflation estimates.
Third, convexity in the preferred stocks sector, which we focus on in this article, is now very close to zero, which means that duration is no longer increasing. This means that while the prices of income securities may fall further if Treasury yields continue to rise, they will not fall at an accelerated rate as they have been doing so far.
Fourth, during periods of recession, credit spreads tend to widen in many asset classes, such as investment grade corporate bonds, high yield corporate bonds, municipal bonds, preferred stocks, bank and other loans. The key point is that credit spreads of higher quality assets tend to increase less than credit spreads of lower quality assets. This is why higher quality assets are likely to outperform and even rebound during a recession. Indeed, Treasury yields often fall more than investment-grade credit spreads rise.
Fifth, the valuation of many higher-quality preferred stocks is not far off the level of high-yield corporate bonds. For example, while the high yield corporate bond index is trading at a yield of 6.64% at the time of this writing, many higher quality preferred stocks are trading at yields around 6%. .
Finally, many high-quality preferred stocks trade well below their “par” level. This means that while the probability of redemption at some point in the future is very low at current yields, it is also not zero. This suggests that there is, in fact, a small chance of a huge tailwind at some point in the future.
A higher quality area of the Preferred Marketplace is Preferred Banks. Within this sub-sector, we would favor low coupon fixed rate securities as they would be more likely to outperform as interest rates decline.
In this sub-sector, we like the following stocks:
- Huntington Bancshares 4.5% Series H (HBANP) is trading at a yield of 6.25%. The preferred issuer is rated Investment Grade, while the issuer is rated Investment Grade by all three major agencies.
- JPMorgan Chase 4.55% Series JJ (JPM.PK) is trading at a yield of 6.18%. The preferred is rated investment.
- Capital One Financial 4.625% Series K (COF.PK) is trading at a yield of 6.44%. The preference is rated investment grade.
We also like the preferred agency-focused mortgage REIT sub-sector. There is only one fixed-rate stock in the sub-sector, namely the Armor Residential REIT 7% Series C (ARR.PC) which is trading at a yield of 7.46%. The stock’s equity/preferred coverage is 6.0x, which is relatively healthy.
Agency-focused mortgage REITs took a hit as the price of agencies fell relative to Treasuries as the Fed planned to reduce its holdings of MBS on its balance sheet. Given current valuations, we are unlikely to see the same pace of weakness going forward, suggesting that mREIT book values should hold up relatively well going forward.
Take away food
Historically, more than three-quarters of the time, the Fed’s tightening cycle has been followed by a recession. This suggests it’s not too early to think about which stocks are likely to outperform in times of widening credit spreads and falling interest rates – the most common combination of market action in a recession. . Higher quality, longer duration securities look attractive places to allocate capital at this stage in order to have drier assets in this eventuality.