Sponsored by Principal Financial Group
L. Philip Jacoby, IV
Executive Director and Chief Investment Officer
Spectrum Asset Management
Please tell me about the history of Spectrum, your investment process and philosophy – how did Spectrum come to manage more than $23 billion in preferred and capital securities?
Spectrum was founded over 30 years ago in 1987. We specialize in managing portfolios of preferred and capital securities for corporate, pension fund, insurance, and endowment clients. We've been doing it for decades. The process is a conservative process fundamentally. We think that the best way to make money is certainly not to lose money. We also manage a suite of open-end and closed-end mutual funds as well as separately managed account programs for high net worth individual investors sponsored by a variety of broker-dealers.
We employ a very conservative orientation within the context of our credit selection. Spectrum uses a fundamental credit-based investment philosophy, leveraging our expertise in capital structure analysis. It starts with credit and then develops into a process of security selection and, ultimately, looking to find that proverbial efficient frontier within the context of a portfolio of preferreds. The market has evolved a lot over the last 30 years. Decades ago, the preferred market was literally just a utility preferred stock market.
Back in those days there was a lot of capital pressure in developing the utility infrastructure. The utilities needed preferred stock in order to manage their senior debt credit ratings being that utilities are very capital intensive and the cost of a downgrade in senior debt was rather burdensome. The utilities were able to recover the cost of preferred stock issuance in their rates making them better able to manage their credit ratings, and therefore to more economically construct the power plants needed to grow America. That was about 1980-1990. From there, the market developed into more of a financials-oriented market because bank regulators wanted Tier 1 preferred securities which fostered market growth through regulatory needs.
Regulation in financial services became more accepting of different types of equity structures like preferred securities in order to enable the banks and insurance companies to be more credit worthy. The market has grown from being just $50 to $60 billion decades ago to now being in excess of one half of $1 trillion dollars, so over $500 billion. Spectrum Asset Management has evolved along with the evolution in junior-subordinated capital securities, which is now a rather significant segment of the fixed income market.
For many investors, when they hear “preferreds” they think of “preferred stocks”. Would you please spend a few minutes explaining what the market is and is not – what kinds of instruments you see – and, very importantly to many investors – where preferred and capital securities fit? Are they equity or debt?
There are lots of different ways to refer to our market. When I say our market, what I'm referring to specifically is this concept of junior subordination. Basically, that means the issuer is able to defer or eliminate payment without accelerating a default.
The very first instrument of this type was a preferred stock. A preferred stock is issued by a charter amendment to the Articles of Incorporation. They are actually share capital instruments that are not dilutive to common shareholders. In other words, they are senior to common equity. Preferred stock is like a bond in that it doesn't share in the growing net worth of the company like a common stock would. But it has a par value, so in other words, it's issued at a par value like a bond and is also issued by charter amendment like a stock, however, it doesn't share in the upside like equity does but it can return a par value. Basically, it trades like a bond based off of a par value.
That was the very first type of junior-subordinated capital security. From that came different types of securities that have evolved over the years, some of which aren't even preferred stock. They're actually bonds. When we refer to a preferred stock, it is exactly that. It is share capital that's non-dilutive and pays a dividend. There are other types of junior-subordinated products that are actually bonds that are issued by indenture. The issuer is able to delay payment or defer payment without accelerating in the event of default. However, if it's a bond, those deferrals can only last for so long — sometimes as long as ten years before that bondholder would actually have the ability to accelerate and push that entity into a default position. Preferred securities are functionally debt-like only because they are not common stock and are not able to share in the upside growth of the underlying entity but pay high income instead.
How does Spectrum approach investing in this market and could you provide insights into your credit process and recommendations?
The process is basically a process which primarily analyzes financials, banks and insurance companies. They issue about 85% of the overall market in preferreds and other types of securities. As a result, the fundamental process of what we do is led by analysis, which we simply call CAMEL. That's an acronym for capital, asset quality, management, earnings, and liquidity. We have various scoring mechanisms that score each one of the letters in CAMEL as they relate to the fundamental attributes; from that, we develop an outlook. Spectrum is able to score, on a relative basis, all of the credits to develop a relative ranking of one entity compared to another and then develop a general outlook on the direction of credit.
So much of your market comprises regulated industries – banking and insurance and non-financials like utilities. What is the regulatory environment like today, and is it beneficial to the credit fundamentals of preferred issuers, especially banks?
The regulatory environment has actually led to a continuing evolution of the preferred market. We have two aspects that we analyze and invest in: preferred stock and junior-subordinated debt. The two combined are referred to as preferred securities.
In addition, the regulatory environment outside of the U.S., primarily in Europe, has developed another kind of junior-subordinated capital security called a contingent convertible capital security, otherwise known as CoCos. CoCos have grown rather significantly over the past seven years from almost zero to a market with AUM of approximately $225 billion. The whole purpose of this regulatory environment is to provide credit stability to the banking system. All this was born out of the financial crisis of 2008 and 2009. From that, the regulators have mandated that banks own more Tier 1 common equity than they had in the past.
Whereas, in the prior period - that is in the period before the financial crisis - banks required capital as only 2.5 percent as common equity Tier 1 capital. Today that requirement is three, four, even five times that amount depending on where that bank is domiciled. Banks have significantly de-risked their business models per this regulatory environment. Their business models are de-risked, and the overall entities are deleveraged.
Banks are basically able, or shall we say encouraged, through the regulatory environment to earn less with more capital. As a result, the return on equity, or the return on assets, hasn't been very supportive to the kind of growth in equity prices that we've seen in the past because of reduced leverage and reduced risk. However, that is very constructive for credit because banks are able to be supported by far more capital than they had in the past. The risk of the banking system entering into another period of significant stress like it had in the prior crisis is significantly less probable now as a result of a considerable amount of regulatory oversight in the sector. That's good for banks. Credit fundamentals for banks are as good as they've been in, literally, decades.
Between COVID-19 and the attendant global economic contraction and even today the lingering effects of the Global Financial Crisis, interest rates globally are lower than anyone could have envisioned a year ago. Can you share your thoughts around your market and outlook over the remainder of 2020 and into 2021 given this environment?
We are seeing a continuation of the central banks supporting liquidity in the financial markets through the expansion of balance sheets. This started just after the financial crisis, where banks would buy treasuries and mortgages — mortgages then being the epicenter of the crisis — in order to provide liquidity to the system. That hasn't changed. Balance sheets, as we speak today, at central banks in the U.S. and abroad are growing because banks are buying financial assets and printing money, expanding their balance sheets in the process of creating currency. That currency helps to create the liquidity that's needed during specific shock events like COVID-19.
There's an old adage: you never fight the Federal Reserve (Fed). Well, that's true. Sometimes the market will lead the Fed into doing something different, and sometimes the Fed will lead the market into adapting. But the bottom line is you never fight the Fed. So, what we have now is a prolonged period of zero interest rates that's called ZIRP (zero interest rate policy). The Fed has told us through numerous press releases that it plans to keep rates low, basically at zero for the foreseeable future. The target funds rate will be 0 to 25 basis points from here to infinity and beyond.
The objective here is for inflation to come back. As we continue to spend our way to proverbial prosperity, the Fed needs to control rates and, essentially, foster an environment which is intended to run the economy hot. In other words, allow it to grow and to grow into a reflationary environment. The Fed always gets what the Fed wants. It's just a matter of time.
We expect interest rates to stay low, but not at zero because inflation will return. It's just a matter of time. And frankly, the speed of that return will largely depend on the outcome of the coming election. Despite rates being at zero, longer-term rates could gradually ebb higher as inflation returns. With the Fed buying bonds to support Main Street, we expect credit spreads to continue to tighten because, ultimately, this leads to a supportive equity market. When equity prices rise, volatility declines. And when volatility declines, spreads tighten. That's the financial physics of it. Spread equals the probability of bad news. When that probability declines because the Fed is supportive, spreads tighten as a result because that bad news, in other words, a risk of a default, is less likely. So, spreads tighten as the probability for bad news declines. And that's what we're seeing.
That is expected to play through the rest of the year and into 2021, which could be a very different year. However, that's really going to depend solely on the election and what happens. Meaning, are we going to continue to be a capitalist society, or are we going to move toward being a socialist society? That has material consequences to the outlook. Frankly, at this point, we are not able to make any prediction. The outlook is basically on hold within the context of credit spreads as equity may be shaken by material socio-economic shifts, but the overall rate structure ought to continue to be supportive, at least for a while longer.
How can investors access the skills and expertise of Spectrum?
There are a number of different ways. We have open funds and actively-managed funds and actively-managed ETFs.
Our open end actively managed mutual fund is NYSE: PPSAX. Our actively managed ETF (NYSE: PREF) invests specifically in thousand-dollar par preferred securities which are preferred securities that are structured for institutional investors. We also offer another actively-managed ETF — NYSE: PQDI. It focuses specifically on preferred securities that offer a qualified dividend income payment or some other type of tax-advantaged payment. So, there's a tax-advantaged element to the investment objective of that fund specifically. A way for retail investors to participate, on the broadest basis, is PPSAX which is in the $25 par market, which is another significant aspect of our market — the $25 par preferreds, packaged for retail investors. It includes the whole gambit of preferred securities and contingent convertible securities. All junior subordinated debt securities can be found in PPSAX. The ETFs are more specific carve-outs to specific sectors of junior subordination. Then there is the SMA (separately managed accounts) platform which can be accessed through broker-dealers and advisors.
Often times, you're going to hear of preferred securities referred to as hybrids. That's really what our products are — they are a hybrid between equity and debt where there is a down-in-capital structure play in quality investment grade-rated enterprises. All of the issuers in our funds are investment grade-rated at the enterprise level. In other words, all senior debt ratings are investment gradee.But when you go down the capital structure into the preferred securities or CoCos, the capital structure just senior to common equity, some of those securities can be below investment grade. It is a down-in-capital structure play in quality companies rather than an up-in-capital structure play in lower-quality companies. In other words, high-yield type companies are a regulated credit reverse play compared to high yield bonds.
Additional resources:
- For standardized performance for PPSAX, click here
- For holdings data for PPSAX, click here
- Click here for standardized performance for PREF
- PQDI standardized performance information can be viewed here
Carefully consider a fund’s objectives, risks, charges, and expenses. Visit principalfunds.com or PrincipalETFs.com for a prospectus, or summary prospectus if available, containing this and other information. Please read it carefully before investing.
Fixed-income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Risks of preferred securities differ from risks inherent in other investments. In particular, in a bankruptcy preferred securities are senior to common stock but subordinate to other corporate debt. Contingent capital securities (CoCos) may have substantially greater risk than other securities in times of financial stress. An issuer or regulators decision to write down, write off or convert a CoCo may result in complete loss on an investment.
Investor shares are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Ordinary brokerage commissions apply.
The market price used to calculate the Market Price Return is the midpoint between the highest bid and the lowest offer on the exchange on which the shares of the Fund are listed for trading, as of the time that the Fund's NAV is calculated. If you trade your shares at another time, your return may differ.
Where gross and net expense ratios differ, the investment adviser has contractually agreed to limit the investment option's expenses. Differences also may be due to the investment adviser's decision to waive (through the same dates) certain expenses that would normally be payable by the fund. The net expense figure reflects the impact of any limits or waivers. Returns displayed are based on net total investment expense.
Performance data quoted represents past performance. Past performance is no guarantee of future results and investment returns, and principal value of the Fund will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than the performance quoted
Unlike typical ETFs, there are no indices that PREF or PQDI attempts to track or replicate. Thus, the ability of the Funds to achieve objectives will depend on the effectiveness of the portfolio manager.
Investing involves risk, including possible loss of principal.
The commentary provided represents the opinions of Spectrum Asset Management and may not come to pass. Any reference to a specific investment or security does not constitute a recommendation to buy, sell or hold such investment security. Past performance does not guarantee future results.
Spectrum Asset Management, Inc. and Principal Funds are part of Principal Financial Group.
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