(Bloomberg) -- JPMorgan Chase & Co. is leading a historic retreat from preferred shares as Wall Street lenders re-jig their balance sheets ahead of new rules that will be significantly watered down.
The bank is planning to repay a $1.6 billion issue next month, at which point it will have reduced its preferred equity by more than a quarter this year. Bank of America Corp. has also redeemed billions of dollars more than it has raised this year, cutting the securities by about 13%. Preferreds are subordinated securities that — similar to Europe’s Additional Tier 1 bonds — count toward regulatory capital.
Lenders spent years growing their Tier 1 capital in anticipation of an update in post-financial crisis rules. They’re now trimming securities used to top up this layer as the final version of the regime — known as Basel Endgame — will be much less onerous than the original proposals, said Federal Reserve official Michael Barr in a speech Tuesday. For banks, reducing Tier 1 capital through the redemption of preferreds is the fastest way to cut the amount they have to pay for capital and can potentially boost their performance.
“Banks have been building capital in anticipation of higher requirements,” said James Benadum, a portfolio manager at Parametric Portfolio Associates, part of Morgan Stanley Investment Management. “Those banks with an excess of CET1 can afford not to replace preferred calls.”
Among big banks, Citigroup Inc. and Wells Fargo & Co. have also redeemed more of the securities than they’ve issued this year. Altogether, it’s been one of the most negative years for net annual issuance for this source of capital since the global financial crisis, according to data compiled by Bloomberg.
Banks have been repositioning their capital while tussling with regulators about the upcoming rules. US regulators’ original proposals for the Basel Endgame — part of a global effort known as Basel III to make banks safer after the 2008 meltdown — were fiercely resisted. After pushback that included threats of legal action and even appeals to the public during NFL broadcasts, regulators staged a dramatic retreat from the original plan.
The revised plan — including a 9% increase in capital requirements, down from 19% in the original plan — will be well received by banks. They’ve built a surplus in their Common Equity Tier 1 ratios of several percentage points, translating to tens of billions of dollars, in anticipation of the rules. Its also a boon for investors in the $200 billion market for US bank preferreds, which have had market-beating returns this year amid a lack of supply.
Frank Sileo, senior fixed-income strategist at UBS, expects shrinking issuance of preferred shares to continue.
“When it comes to the bank space, the trend of redemptions outpacing new issuance may continue and, if anything, supply may slow as we get closer to the election period and the broader market volatility around it,” he said.
Performance Boost
All this has created a positive backdrop for the preferred shares market. They’ve already earned about 11% in total return this year, according to ICE BofA indexes, outstripping gains in high-grade bonds and junk debt. That’s partly because investors are chasing a smaller amount of the securities.
And money has continued to flow into the asset class this year. Investors have added almost $1.5 billion to US funds specializing in preferred stock through the end of July, according to data from Morningstar Direct.
Even if supply picks up once regulators offer more clarity on the new rules, “we still see an overall supportive technical backdrop for the broader bank preferred asset class,” CreditSights analyst Jesse Rosenthal wrote in a note to clients last week.
Representatives at JPMorgan and Citigroup didn’t answer questions about preferred shares. Spokespeople at Wells Fargo and Bank of America declined to comment.
To be sure, banks are unlikely to abandon preferred stock entirely given its cost benefits and the flexibility it gives them. The securities tend to be cheaper than common stock and can be repaid more easily — but must only account for a limited share of banks’ capital. Two of the biggest names on Wall Street — Goldman Sachs and Morgan Stanley — have been net issuers this year.
Still, banks have little urgency to tap the market before the new rules, scheduled to take effect in mid-2025, are finalized, setting the backdrop for further redemptions and more outperformance.
(Updates with reference to Michael Barr’s comments in third paragraph.)
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