Preference Market Review: Fixed/Float Gets a Boost
This article was first published to Systematic Income subscribers and free trials on February 13.
Welcome to another installment of our weekly preference market review where we discuss activity in the preferred bond and baby bond market both from the bottom up, highlighting individual news and events, as well as top to bottom, providing insight into the broader market. We also try to add historical context as well as relevant themes that seem to be driving the markets or that investors should be aware of. This update covers the period up to the second week of February.
Be sure to check out our other weekly updates covering BDC as well as CEF markets for insights across the entire revenue space.
It was another weak week for preferred stocks, with the average sector down about 1%. This is despite longer-term Treasury yields holding steady over the week, although short-term yields rose on a surprise inflation print.
Year-to-date, the preferred stocks sector is down around 4%, with higher quality sectors such as banks and insurance underperforming (due to a lower coupon/duration profile longer), while a few idiosyncratic names from the telecommunications sector, namely COMSP and the BDC Sector, i.e. PSEC.PA lead to underperformance.
February’s weakness has already surpassed January’s, with February being the worst month since March 2020. Three of the past four months have been the worst performers since then.
The upside of this weakness is that the median-at-worst yield has risen nearly 5.5% from around 3.5% in mid-2021. This rise in yield is well above the action of Treasury yields for all maturities and supports the preferred share market as many higher quality securities are now trading at yields 5% or more than 3% above the yield of 10-year Treasury bills.
In the previous weekly, we discussed how low-coupon preferred stocks underperformed during the recent interest rate hike due to their longer duration profile. This week, we’re talking about another key variable for investors to keep an eye on, which is coupon structure, specifically fixed vs. fixed/floating coupons.
Fixed/float preferred securities are those that feature a change in their coupon from a fixed to a floating rate, such as Libor (a proxy for 3-month unsecured bank rates) or CMT (Constant Maturity Treasury which is usually the 5Y Treasury yield, reset every 5 years).
The recent bearish flattening of the yield curve, where short-term rates have risen faster than longer-term rates, remains a key theme in the income arena, and particularly for preferred stocks. Year-to-date, 2-year and 10-year Treasury yields have risen 0.77% and 0.40%, respectively.
This rapid rise in short-term rates has favored fixed/floating equities over fixed rate equities, as shown by the following year-to-date performance trajectory of the banking sector.
If we break down an issuer’s performance to monitor credit quality, we get the same result. Series J and K Goldman Sachs are Libor fix/float while the other 3 series are fixed rate (they are technically floating rate but have a high fixed rate floor and a low spread over the Libor that they are essentially at fixed rate ).
The key takeaway here is that not only should investors follow obvious things like credit quality, but they should also keep an eye on the level and structure of coupons – two key drivers of interest rate sensitivity. . In other words, relative performance in the preferred stock market is determined by both the level of yield (which results in differential performance between coupon levels) and the shape of the yield curve (which results in a differential performance on the coupon structure, i.e. fixed and fixed/floating series).
A final point to remember is to beware of the old saw that “fixed/floating preferences have lower duration”. This may be correct when rates are rising, but precisely incorrect when rates are falling. This is because when short-term rates fall, fixed/floating securities’ coupons are more likely to reset to lower levels, which will lengthen their duration exposure. And, perhaps more intuitively, this makes these series unattractive, as investors will tend to flock to securities that are not subject to a coupon reduction on the first call date.
On the service, we discussed a comment we sometimes hear regarding Prospect Capital Corp 5.35% Series A (PSEC.PA) stock which has not performed well since its IPO, this is the less to say, trading at $19.92.
The comment we’re hearing is that the stock simply shouldn’t have been issued at 5.35% and its below-market coupon explains its subsequent fall. This view ignores history – PSEC.PA was issued when the BDC debt sector was trading at a yield of less than 2%, so a preference with a recovery in yield of around 3.5% from a BDC which (despite the fact that many investors hate her) has generated some of the strongest total net asset value returns over the past 5 years and boasts one of the lowest levels of leverage in the industry (this is somewhat offset by the built-in leverage of its holdings in CLO shares).
The table below shows the timing of the PSEC.PA IPO and where BDC’s debt sector was trading in worst-case yield conditions. If the BDC debt sector had been trading at yields of 4-5%, then the argument that the 5.35% PSEC.PA the coupon was too low could hold water but was trading below 2% at the time.
Second, PSEC had a baby bond outstanding (PBC) at the time of the IPO, which was also trading at a worst-case yield of less than 2%. A 3.5% yield rally in preferred stocks with very high coverage and low leverage is attractive, regardless of the backseat comments we sometimes hear.
Based on Q4 numbers and $500 million of preferred issues (based on recent press release), equity/preferred coverage is 8.4x, which is very high as it goes. , especially given 1) PSEC’s focus on secured lending (its REIT and CLO equity allocations are more volatile and cyclical, but they’re at smaller allocations in the portfolio) and 2) the PSEC’s low leverage, which means there is relatively little debt in front of the preferred stock.
Given all of this, preferred stock is still whole (i.e. it recovers 100%) if the company’s assets lose 60% of their value (on the GFC, its assets lost about a third of that number). In the worst case (when the private preferred issue reaches $1 billion), the assets can lose 55% of their value and the preferred shares will still be whole.
Of course, the decrease in PSEC.PA is unpleasant, but it highlights the occasional tendency for investors to 1) complain about low returns and few opportunities and 2) then complain about falling prices despite the fact that lower prices represent higher returns attractive. Conviction helps bypass this wasteful style of investing, but that can be easier said than done.
It’s worth taking a quick look at the Q4 PSEC results to see if there’s anything fundamental to the business. The NII rose from $0.209 to $0.219 and the net asset value increased by almost 5% – the highest value in the BDC sector among companies that have reported so far. Non-counts have gone down, as have PIK revenues. Leverage increased slightly to just 0.51x – the lowest in the industry. This highlights that there is clearly nothing wrong with the fundamentals, i.e. the movements in PSEC.PA are technical and likely linked to a shift from public to private preferred. The yield gap between the two has increased and rotation will start to make much less sense despite the attractive but misleading optics of keeping the private preference price pegged to “par”.
mREIT Two Harbors Investment Corp (TWO) reported results – book value fell 8%, again due to widening agency spreads. Equity-to-preferred-share coverage remained about the same at 3.8x as the company issued common stock in the fourth quarter. Leverage increased from 6.1x to 4.7x. Series A TWO 8.125% is attractive to us (TWO.PA) due to its high coupon and Fix/Float profile with a high spread to Libor resulting in interest rate sensitivity weaker. The stock is also trading at the YTW 3-series high of 7.97% (yield reset to 7.51% based on Libor futures) and has a long first call date of 2027, which provides a call protection measure.
With the banking sector underperforming, stocks in the high-quality sector are starting to look attractive, with many trading 3.5% above the 10-year Treasury yield. We like Huntington Bancshares 5.7% Series I (HBANM), trading at a yield of 5.73%, Regions Financial 5.7% Fix/Float (RF.PC) at a yield of 5.36% with a very long buy date in 2029 and the non-callable Wells-Fargo (WFC.PL) at a yield of 5.61%.