Income investors are generally aware that long-maturity bonds are more sensitive to rising inter-est rates (measured by U.S. Treasury yields) than short-term bonds. That’s one reason the 10-year yield is usually higher than the 2-year yield, resulting in a “positive yield curve.” You get a higher interest rate on the longer-maturity bond to compensate you for its greater downside if rates rise.
|Median Price Change by Maturity--April 2018|
|BBB Corporate Bonds||BBB Preferreds|
|1 to 3||-0 .28||1 to 5||-0 .37|
|3 to 5||-0 .68||5 to 10||-0 .84|
|5 to 10||-1 .23||10+*||-0 .98|
|10 to 15||-1 .51|
|15+||-2 .04||Perpetual||-1 .00|
|*Excluding perpetuals. Source: ICE BofAML Index System|
Forget theory. What actually happens when rates rise?
Applying that same logic to perpetual preferreds may cause some investors to freak out. If bonds with maturities of 10 or 15 years drop a lot when rates rise, shouldn’t infinite-maturity maturities go straight to the basement when that happens? That’s a credible hy-pothesis, but what matters is what happens in practice.
To determine how perpetual preferreds actually behave when rates rise, we compared price changes, sorted by maturity range, on BBB corporate bonds and BBB preferreds1 in April 2018. Why that month? In April 2018 the spread-versus-Treasuries on invest-ment grade corporate bonds barely moved, declining by a negligible 1 basis point (= 1/100 of a percent). That is to say, the month’s price declines on income investments were almost entirely a function of the rise in underlying Treasury yields. Changes in investors’ appetite for credit risk played no meaningful role.
Treasury rates rose significantly in April 2018. The yield increases were 21 basis points on the 2-year and 20 basis points on the 10-year yield. That meant the price declines in the various maturity buckets weren’t materially affected by non-equivalent yield increases in the corresponding Treasury maturities.2 Neither were differences in credit quality among the buckets significant, since we concentrated solely on the largest rating category, BBB. Our findings appear in the accompanying table.
For bonds as well as for preferreds, the longer the maturity, the more the price fell in response to April 2018’s interest rate rise. No surprise there. But note something less expected when we compare the various price changes: Perpetuals fell only slightly more (-1 .00%) than the longest non-perpetual preferreds (-0 .98%) and less than even the 5 to 10 year bonds (-1 .23%). In short, fears of a colossal price drop in perpetutal preferreds are not justified by experience.
That’s the right lesson to draw for now. A large percentage of preferreds are currently trading above par, so their sensitivity to an inter-est rate rise is suppressed by their susceptibility to being called. If prices fall sufficiently to eliminate any likelihood of calls, interest rate sensitivity will increase for preferreds in general. We’ll address that scenario in a future report.
1 This analysis was based on the ICE BofAML Fixed Rate Preferred Securities Index and the ICE BofAML US
Corporate Bond Index.
2 The rise in the 30-year Treasury yield was somewhat smaller, at 13 basis points. Because the preferred universe is much smaller than the bond universe, we broke it down into fewer maturity buckets in order to maintain sufficient sample sizes in each