- Fixed Income Portfolio Manager
United States, Institutional
Change
The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Key points
- Capital securities are hybrid investments that can share characteristics of both bonds and stocks. Examples include cumulative preferred stock, additional tier 1 capital, and junior subordinated debt.
- We believe that capital securities represent a structurally inefficient asset class with attractive income, return, and alpha potential that may appeal to many types of investors.
- Investors who pay taxes and/or consider returns relative to underlying credit ratings may find the value proposition particularly compelling.
Capital securities are a nuanced and overlooked asset class that, in our view, may be an attractive addition to a broader fixed income portfolio. A hybrid asset class that can share characteristics of both bonds and stocks, capital securities include structural features that provide corporations with regulatory or rating agency capital treatment without diluting common shareholders. Issuers often pay rates on capital securities well above those of senior bonds, subordinated bonds, and equity dividends. We believe that there are enduring structural inefficiencies in the capital securities market that provide the potential for a compelling risk/reward profile for investors.
High-yield potential from higher-rated securities
For the 10-year period ended 30 June 2024, capital securities (rated BBB3) matched the pre-tax returns of high-yield corporate bonds (rated B1) on a total and risk-adjusted basis (Figure 1). Approximately 66% of the yield of capital securities as of 30 June 2024 came from securities rated BBB or higher. For high-yield corporate bonds, 56% of the yield came from securities rated B or lower. Put simply, the historical returns and present yields compare to those of high-yield corporates but come from higher-quality credits.
Figure 1
Structural inefficiencies and a wide dispersion of returns
Capital securities are a complex, segmented, and overlooked asset class. We believe that structural inefficiencies in the capital securities market create enduring alpha potential for active managers. The dispersion of capital securities returns is comparable to that of high-yield corporate bonds (Figure 2), providing ample opportunity for idiosyncratic returns. We think the key to capturing this alpha potential is understanding structural complexity rather than assuming material risk of non-payment.
Figure 2
Tax efficiencies
While not germane to all strategies, many capital securities may offer tax benefits to individuals (qualified dividend income or QDI) and corporations (dividends received deduction or DRD). These tax benefits could make capital securities a more attractive opportunity on an after-tax basis (Figure 3).
Figure 3
Potential roles for capital securities
We believe that investors can benefit from exposure to capital securities given the diversification, income, and return potential of the asset class. With valuations well north of historical median levels and only moderate correlations to other markets, we think capital securities currently represent a compelling opportunity and could be a complement to a broader opportunistic fixed income allocation.
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