This article was first released to Systematic Income subscribers and free trials on Nov. 13.
Welcome to another installment of our Preferreds Market Weekly Review, where we discuss preferred stock and baby bond market activity from both the bottom-up, highlighting individual news and events, as well as top-down, providing an overview of the broader market. We also try to add some historical context as well as relevant themes that look to be driving markets or that investors ought to be mindful of. This update covers the period through the second week of November.
Be sure to check out our other weekly updates covering the business development company (“BDC”) as well as the closed-end fund (“CEF”) markets for perspectives across the broader income space.
Preferreds had a terrific week alongside the rest of the income space. mREITs significantly outperformed due to their relatively higher-beta profile as well as their oversold status, in our view, something we highlighted recently.
Price action in November has reversed all of the October and some of the September drop.
Yields fell slightly below 7% but remain very attractive historically.
An important driver of performance across the preferred sector is the change in short-term rates. With the recent downside surprise in inflation and the Fed’s downshift in its hawkish rhetoric, the market is pricing in a pause and an eventual fall in the policy rate as shown below.
As many preferred investors are well aware, a drop in short-term rates has a significant impact on the future coupons distributed by floating-rate preferreds and fix/float preferreds. As short-term rates spiked this year, fix/float preferreds with short first call dates performed the best. This was because these stocks were going to be able to take advantage of the rate spike earlier, allowing them to boost their coupons. This expectation of a sharp coupon boost supported their prices.
As the chart below shows, fixed-rate preferreds and fix/float preferreds with longer-term call dates (ie, those with a longer wait before potentially switching to high floating-rates) struggled the most this year. Preferreds which were going to switch to floating-rate faster (ie, those with 0-1Y first call dates) tended to perform very well. The chart aggregates only investment-grade preferreds in order to control for quality.
Perhaps a more intuitive way to show the same dynamic is to consider a single issuer – Annaly Capital Management (NLY) – the year-to-date performance of whose preferreds is shown below. NLY.PF which has recently converted to a floating-rate has performed the best. NLY.PG which will convert to a floating rate in 2023 is second and NLY.PI which will convert to a floating rate in 2024 is third. This all makes sense. Because floating-rate coupons will exceed their previous fixed coupons (due to unusually high short-term rates), the earlier investors can get their hands on the higher coupon the more the preferred benefits given.
An important part of investing is to make sure not to extrapolate current trends forever. And just as short-term rates have jumped this year, they will not continue to rise at the same pace. In fact, they are very likely to pause and possibly fall next year, particularly if the broader economy enters a recession.
What this means is that fixed-rate preferreds which underperformed this year could easily outperform next year. This is exactly what happened in 2020 as the US economy entered a brief recession and as the Fed cut rates. That year floating-rate and fix/float preferreds struggled because short-term rates were cut to a near-zero level very quickly. And although few people expect this to happen in 2023, some drop in short-term rates is very likely.
This means that investors who may have correctly overweighted near-term reset fix/float preferreds earlier this year should now consider building up their allocation to fixed-rate preferreds or to longer-term reset fix/float preferreds. This is not only because of the potential impact of rate changes but also because near-term reset fix/float preferreds have gotten very expensive. For example, we recently switched to NLY.PG from NLY.PF in our Income Portfolios.
In the fixed-rate subsector we particularly like higher-quality, lower-coupon preferreds which boast relatively high duration. This includes COF.PJ, KEY.PK, WFC.PC and other bank preferreds trading at yields well north of 6%.
We don’t expect the 2020 episode to repeat itself since inflation is likely to remain sticky and the macro shock is unlikely to be as sudden and deep as it was in 2020. That said, it does make sense for investors to start considering longer- duration exposure given we are much closer to a Fed pause / pivot.
Mortgage REIT Two Harbors (TWO) released Q3 results. While book value was down sharply as expected there were some easily overlooked positives as well. First, the company bought back 2.9m shares of preferreds in Q4 or 10% of outstanding shares. In addition to lifting equity/preferred coverage and supporting prices, it also boosted book value by around 1.5% during the quarter as well.
Secondly, the company continues to issue common shares either through its at-the-market program or through secondary offerings. This tops up its equity and further improves the coverage of the preferreds. The net result is that even though the drop in book value was large, the drop in the equity/preferred coverage was fairly marginal – to 3.3x from 3.4x. These preferred-friendly actions are one reason why the preferreds remain attractive. We continue to hold TWO.PA in our High Income Portfolio. The shares trade at a 10.2% stripped yield.
BDC Prospect Capital (PSEC) results came out which are more interesting in the context of preferreds. There is now about $1.2bn of preferreds across various classes. The company increased its previous $1bn program to $1.75bn. They also had to increase the coupons of their private preferred to 6.5%. It’s not at all clear why anyone would find a 6.5% non-traded PSEC preferred appealing when both BBB-rated corporate bonds and bank preferreds trade around this yield and when the public preferred PSEC.PA trades at an 8.1% yield. It seems that wealth managers are finding low-information clients to stuff it into their portfolios with the main appealing factor being that the price doesn’t move so they don’t have to get worried calls from clients in case of a drop.
Current equity / preferred coverage is around 4.1x which is very adequate for PSEC.A particularly as the amount of debt is low and moving lower (PSEC has made a tender offer for its 2023 bond). The preferreds are still whole ie, covered by sufficient equity even if the entire PSEC portfolio is somehow cut in half from today’s level. This provides more than sufficient coverage of PSEC.PA which we continue to hold.