Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name’s Stewart Foley, I’ll be your host. Welcome back. Today’s topic is preferred and capital securities. And we’re joined by Phil Jacoby, Executive Director and Chief Investment Officer of Spectrum, a wholly-owned subsidiary of Principal. Phil, thanks for being on, man. We appreciate you taking the time.
Phil: I’m very happy to be here. Thanks for having me.
Stewart: Well, we’re going to start this one like we start them all. What’s the town you grew up in? Your first job? Not the fancy one. And a fun fact?
Phil: I grew up in Milford, Connecticut, small seaside town.
Stewart: It’s beautiful there.
Phil: Back in the day, reminds me of The Wonder Years. Do you know that old series, The Wonder Years? That’s what it reminds me of. First job was in Chicago, in fact, at the Northern Trust company. I started there right out of school, and worked in trust services, and learned how to receive trust assets in from the wealthy clients, and basically code them into the trust program there at Northern Trust. And, eventually, ended up trading preferred stock in the insurance company advisory service of the Northern Trust.
Stewart: You’re an insurance asset management OG. That’s amazing. What a great background.
Phil: Yep, yep. That was many, many moons ago.
Stewart: And how about a fun fact?
Phil: A fun fact. That’s a tough one, man. I don’t know about a fun fact.
Stewart: All right, we’ll go with what’s up next year. So you are the Chief Investment Officer of Spectrum. Can you talk a little bit about your background and a little bit about Spectrum? Just for those folks who might not be familiar, just so that we can center the conversation, just starting there.
Phil: Yeah, sure. Well, my background, after getting a good taste of the buy side of the street as a young guy, I wanted to go into the sales side of the street and sell bonds and do what all those guys did that called me on the phone. So I was an institutional salesman for EF Hutton, back in the ’80s.
Phil: Yeah. And I had a little specialty in preferred stock at the time and sinking fund preferred stock. So that was my little go-to as a fixed income salesman. From there, I wanted to go back onto the buy side, because I just enjoyed managing money, and didn’t quite like telling clients that they should be buying a bond that I really didn’t feel all that convicted in. Of course, the traders had to move their paper, and that’s what you do on the sell side of the street.
So from there I went to a division of Ford Credit called USL Capital and at the time, there was a carve-out in the tax code that said that you could deduct the interest on loans, to the extent that interest and commercial paper was a significant part of your business. Of course, with finance companies, that was a significant part of their business. And that code was basically written into law because there was a huge, huge amount of capital pressure on the utility industry, back during the periods where utilities were building a lot of nuclear plants.
So, of course, those plants had to have capital. And finance companies at the time were big, big providers of that capital, to help support the more senior ratings of those utilities. They would basically issue subordinated debt, senior debt and then look to get some equity credit funding with preferred stock, in particular, sinking fund preferred stock. So the finance companies, like Ford Credit, USL Capital, would purchase sinking fund preferred and deduct the interest expense, and get the benefit of the dividend-received deduction. So their return on equity was 50% – 60%. So that was a big game back then.
And then the markets changed, and banks became needy of capital. This is the early ’90s now. And then, in the mid/late ’90s, the whole industry changed, when trust preferred were invented, literally, by investment bankers in cooperation with banking regulators. That, of course, became a big deal, where investors could get an extra 50 basis points relative to sub-debt, which at the time was quite a spread. A dated paper, tax deductible for the issuers, but providing some equity credit as well. And, of course, investors and, in particular, insurance companies were very yield-hungry. And there were literally lines at the syndicate desk waiting to buy the next deal, when the first trust preferreds came. But then they proved not to be as sufficient in providing needed capital to the industry when the financial crisis came. Now, we’re talking 2008, 2009, of course.
So, basically, a preferred security at the time would allow a passing of a dividend. And these were preferred securities, so it was actually debt capital, junior subordinated debt capital, held in a trust. And the trust would sell the preferred security. But underlying that trust, the look-through was actually a subordinated debt issue to that trust and, therefore, tax deduction available, and some equity credit available and some benefit to the regulator. So when the crisis happened, and dividends needed to be passed, or interest payments, that is, needed to be passed, because it was debt, it was cumulative. And because it was cumulative, they could, of course, save the tax, or the interest expense, and the cash debit of that expense. But they had to accrue that liability on the balance sheet. So it didn’t give them all that they wanted. They could save cash but accrued a liability to do it. So that was viewed as being a flaw, or something not quite good enough for the regulators.
And, from there, they changed the rules and needed Tier 1 capital to be non-cumulative preferred stock. So it went from being debt and cumulative, to being actual share capital and preferred stock, and perpetual, and non-cumulative. So, therefore, payments are passed, much like what’s just happened here with First Republic. Those payments are not accrued in the balance sheet. They’re actually passed and skipped and there’s no acceleration of bankruptcy in the process of that happening. So that’s been a bit of the evolution.
And on the European side in banking, the same process played through as well, but a little different. The AT1, or additional Tier 1 securities, there, are not preferred stock like it is here in the U.S. But, rather, it’s contingent convertible capital securities which, in some cases, is actually debt. So they actually get a tax deduction, depending on their own tax rules in that country. But it’s perpetual debt. And there’s triggers on capital that would require it to be written down to zero under certain instances of stress, and the potential for non-viability. So it’s a little bit more junior payments are pari passu, in CoCo’s to common equity dividend payments.
Whereas, here in the U.S. the whole idea of a preferred stock is to have the dividend being preferred to the common dividend payments. In other words, the payment on preferreds come first. And the only way for a payment to be stopped in a preferred stock is for the common equity dividend payments to be shut off first. So there’s actually a priority of dividend payment in a preferred stock. But not a priority of payment in a CoCo security. So they’re a bit more junior down the capital structure in that respect.
Stewart: And just for folks who may not know, when you say CoCo, what is CoCo short for?
Phil: Yeah, CoCo’s an acronym for contingent convertible capital security, so CoCo.
Stewart: Got it. Thank you. So your focus, and the focus of our podcast, is preferred and capital securities today. Can you help us navigate the current environment, and what you see coming. Obviously, a lot’s happened. Markets have been moving around a lot. Help us level set where we are and what’s next?
Phil: Well, the market has been evolving quite a bit. And so have the factors in the risk-based capital (RBC) charges for insurance companies, as we know. So there’s a bit of a balance there between the yield available for capital securities and net of those RBC charges. And what you can get going up the capital structure in more senior bonds. So what’s coming is, really, what’s already come. And that is that the evolution has brought to us today preferred stock, actual share capital, down the capital structure. Just senior to common equity, but junior to subordinated debt. And, also, CoCos in the non-U.S. banking system, Which, depending on the regulatory regime, they’re supposed to be senior to common equity. But certainly junior to senior debt and subordinated debt. So more of the same, basically.
The regulators wanted Tier 1 capital, which is predominantly what preferreds are. Insurance company issuance and banking issuance make up the lion’s share of preferred stock. There are some utilities, some industrials, as the case may be, but about 80% banking and insurance. So we refer to the sector in a lot of cases by referring to Tier 1, which is bank issuance. So Tier 1 has a bit of a KISS, if you will, on tax subsidy. Because there is a dividend received deduction (DRD) available to corporations so they’re not double taxed. So you can get a DRD KISS or benefit to it. Now, that really is dependent on the unique attributes of the insurance company, its state, and so forth. So it’s hard to put a number specifically on what that KISS is. It can differ, from life to P&C, for example. But the companies know. And we help to find some economies within the context of what they tell us.
So you’ve got that, plus just the gross yield, where you get anywhere from, let’s say, 200 basis points over senior debt for a preferred stock. And about 325 basis points over senior debt for a contingent convertible capital security. So quite a bit of yield. And, really, it’s a down in capital structure play in quality companies. So, at least for Spectrum anyway, we invest only in preferred stock issuers that have an investment grade rating on their senior debt. So we are fully invested, at the enterprise level anyway, in securities that have enterprise investment grade ratings.
So when you go down the capital structure, at that base case enterprise investment grade level, you go down the capital structure, let’s say, one notch from senior to sub. Another notch into preferred, and maybe another notch in the non-cum or below investment grade. So 2 to 3 notches for preferred, and 3 to 4 for CoCos. So you’re looking at BBB- to BA1 or BA1 – BA2, depending on the issuer in CoCo. So it barbells that below investment grade area to where we can get a weighted average investment grade portfolio. And, of course, at the CUSIP level, where we have the enterprise grading still being anchored in the B, AA1, A- category.
Stewart: So you mentioned Spectrum and the way that you invest. Can you talk a little bit about Spectrum and the relationship to Principal, and your philosophy and approach? As you mentioned at the top of the show, the overwhelming majority of your career has been spent in these securities. And that’s amazing. That’s a tremendous amount of expertise, and what I would refer to as tribal knowledge. So can you talk to me a little bit about Spectrum and that background, and your philosophy and approach to these securities?
Phil: Yeah, sure. Well, yeah, the team, we’ve been around the block a bit, so we’ve seen a thing or two. And we’ve actually been able to gain some of that tribal knowledge, as you’ve referred to, and gain some wisdom in the process. And looking back and seeing what things seem to be repeating themselves or, if you will, without rhyming with things that we’ve heard in the past. So our philosophy is very conservative at the credit level. We’re going down the capital structure. So we seek to get our yield anchored in good quality investment grade-rated enterprises, without taking extraordinary risks to do that. Because the risks that we’re taking are to go down the capital structure and live in that lower quality sector, or more risky sector, if you will, for payments as agreed in that down and capital structure play.
So it’s a very conservative philosophy from a credit orientation. And I think that that’s been proven to be beneficial over the longer period, rolling 2 to 3-year, 5-year, type investment periods. So we like to be, shall we say, a little less good and a little less bad, and come out the middle ground. And have less of a sine wave to volatility on our returns than our competitors have experienced. So that’s our basic philosophy and our approach to credit.
We have quite a bit of knowledge on the CUSIP level attributes toward issues. These can tend to be very complex issues, and have complex structures. And we seek to benefit from understanding these structures, a lot of which are fixed or re-fixed. Which is pretty unique, I think, anyway, for an insurance company that is keying on book yield. Because fixed or re-fixed, especially in today’s market, can be purchased at, let’s say, a discount, let’s just say $85, for example. And you get a re-fixing of that coupon, let’s say, 5 years forward, which is the standard re-fixing. So as time ages, 5 years becomes 4 years, becomes 3 years, becomes 2 years, and that re-fixing comes closer to being term, or executed, at the then current level of 5-year treasuries. If rates are rising, or have risen, like they have currently, you can actually get an increase in income. So you get a bit of a pull toward par, as the bond ages toward that re-fixing, if that coupon is going to go higher in payment.
If I was going to go lower, well, then it’s probably true that the company would refinance. And the preferred would behave like a 5-year bond, and get refinanced and redeemed and replaced. So you get par back, that’s not a bad thing. To the extent you don’t get par back, and you’re going to get a reset coupon, you get a pull toward par. And the prospect of that 85% book cost having now not a 3.5% dividend, but a 5.5% dividend. So book yields can actually rise, without trading a single security, which is quite unique, especially for something that is a perpetual, which needs to be mark-to-market. So you’ve got a bit of a defensive orientation to the structure in portfolios that are perpetual and need to be mark-to-market on Schedule D2.
Stewart: You’re speaking the language of the insurance investor. So you’re owned by an insurance company, and you’re managing these strategies for insurance companies. And I’ll roll forward. Why should insurance investors consider an allocation to preferred and capital securities? You’ve touched on this, and you’ve talked about it just now. And I just want to make sure that, if there’s anything that I’ve missed, I want to make sure I’m giving you the chance to talk about the insurance investment community in particular.
Phil: Well, the unique aspect to the insurance community is the risk-based capital charges that are required per the investment. And the accounting measures that are required for that same investment, mark-to-market, held in maturity, lower cost to market, as the case may be. So there’s going to be different preferences and balances required there, overall, for the overall portfolio on a general account. So you can take preferreds and, in essence, optimize your return on risk-based capital, net of those risk-based capital charges, by the additional yield for one. And the, somewhat limited historical default, number two. But, more importantly, those yields net of risk-based capital. So, for example, in a CoCo, you can get better than 8% on a return on risk-based capital. Let’s just say, it’s your net yield, or your book yield, times that 1 + the RBC charge, just very simply. You can take that book yield on a CoCo, and get a yield which is either equal to or greater than, depending on market demands. Right now, CoCo yields, just on average, a little bit greater than the high yield benchmark index is.
But then you’ve got a much lower risk-based capital charge. So when you look at the return on invested capital, you can get more in a CoCo than you can in a high yield bond. So high yield bonds are often compared to CoCos because both are predominantly below investment grade. And the same is true for preferred securities or preferred stock, relative to the more senior bonds. So there’s a bit of an optimization opportunity, without taking extraordinarily extra credit risk to do that, by going down in the capital structure, in these quality investment grade rated enterprises. So it’s an optimization opportunity, if you will, to better earn returns on that risk-based capital that’s required of insurance companies to monitor.
Stewart: I’m a certified insurance asset management geek too. I have not spent a lot of time on these securities. Are there misconceptions that an investor may have about these in the market that creates this relative value? Can you talk a little bit about that?
Phil: Yeah, I think the misconceptions are oriented around the actual risk given default. And what we’ve found over the years, just looking at the 10-year average history of default, is that preferreds—and we’ve been through some doozy credit cycles. The actual history of default, on average, is far less than it is on high yield. For example, I’m doing some back of the envelope adjusting for some of the more recent defaults in the news lately. And I’m going to say the average 10-year default for preferred securities, including CoCos, junior subordinated capital securities is about 45 basis points, on average, for the past 10 years. And that compares to, I would say, let’s just say 10 for a round number, for investment grade corporate bonds. And about 2.5% for high yield. So the loss given default risk of a preferred is not as high as some people think that it is, in reality. And you’ve gained a lot of yield in addition to help offset that.
And you also, at the corporate level, get a nice tax to boot. Just that tax KISS to boot could be worth about 2 standard deviations of average spread, over the prior credit, through 3 credit cycles, for example. So that little KISS gives you, let’s say, 4th and 5th standard deviation type benefits in your pocket. So it’s a pretty good bet, we think, when you look at historical default, yield, and liquidity is there. These are big issues, in the corporate bond world anyway. So you’ve got good liquidity as well if you need that, especially if that’s held in portfolios that are mark-to-market. You got to mark them, and you got to have good marks. And liquidity’s there to do that.
Stewart: That’s really helpful. So when I’m interviewing a subject matter expert like you, I put on my insurance CIO hat. And when I’m looking out, through the end of 2023 here, and I’m trying to figure out what to do with my next marginal dollar, what would you encourage insurance investors to consider from here out?
Phil: Well, I think spread’s important. And when you look at issues that need to be mark-to-market, perpetuals, for example, or even lower cost, or market, you want to buy a spread. Because that improves the probability of your mark not going as low as it would otherwise, if you were buying them, for example, at a tighter spread. So, right now, spreads matter, of course. If you believe in the migration back toward the mean, under the area of a standard normal curve, you’re going to have that mean regression. And when you can get preferred spreads, and even relative preferred spreads…not just absolute, but in a relative toward more senior alternativesthat are 1.5 – 2 standard deviations wide at average; it’s a pretty good bet that you’re going to get some supportive aspect or element play through, as that time ages and mark-to-markets happen, to where spreads are tightening.
And those mark-to-markets aren’t going to be as impactful on the balance sheet as they would be to the extent you were buying them at one standard deviation tight of average, compared to one standard deviation wide of average. You’d much rather have that migration toward the mean work in your favor in a mark-to-market in more probabilistic ways than in your disfavor. So, now, given the point in the credit cycle that we’re in, we’re about 1.5, 2 standard Ds wide of average. So it’s a good place to start scratching your head.
Stewart: Phil, I can’t thank you enough for being on. I’ve learned a bunch today. And I had a new question for 2023 as a wrap. I hope you like it. Who would you most like to have lunch with, alive or dead?
Phil: Jesus Christ.
Stewart: There you go. You’re the second person to come up with that answer. That’s very nice. Very cool.
Phil: It’s the God’s honest truth.
Stewart: There you go.
Phil: Now, there’s your fun fact.
Stewart: There’s the fun fact too. We got that out of the way as well. So thanks for being on. We’ve been joined today by Phil Jacoby, Executive Director, and Chief Investment Officer at Spectrum. Phil, thanks very much for taking the time.
Phil: Thanks for having me, appreciate it.
Stewart: My pleasure. If you like our podcast, please rate us and review us on Apple Podcast. We really appreciate you taking the time to listen. My name’s Stewart Foley, and this is the InsuranceAUM.com podcast.
Spectrum Asset Management and InsuranceAUM.com are not affiliated.
This material is provided by and reflects the current views and opinions of Spectrum Asset Management, Inc., an affiliate of Principal Global Investors. Spectrum is a leading manager of institutional and retail preferred securities portfolios.
Past performance is no guarantee of future results and should not be relied upon to make an investment decision. Investing involves risk, including possible loss of principal.
Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline. 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.
Principal Asset ManagementSM is a trade name of Principal Global Investors, LLC.
Principal®, Principal Financial Group®, Principal Asset Management, and Principal and the logomark design are registered trademarks and service marks of Principal Financial Services, Inc., a Principal Financial Group company, in various countries around the world and may be used only with the permission of Principal Financial Services, Inc.
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