Preference Weekly Review: Are the fixed/floating preferences of 2024 under threat?
This article was first published to Systematic Income subscribers and free trials on June 25.
Welcome to another installment of our Preferred Markets 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 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 fourth week of June.
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 a good week for preferred stocks as almost all income sectors were up. Recent flow data recorded retail capitulation in stocks and that probably eliminated a lot of weak hands in favorite stocks as well, providing a stronger base for a rally. In addition, a downward revision to inflation expectations from the University of Michigan as well as comment from the Fed’s James Bullard continued to support income assets.
Despite the rally, however, June is shaping up to be the worst month since the COVID crash.
Premium yields continue to trade at very high levels – due to an unusual rise in Treasury yields as well as credit spreads. Interestingly, current yields are not far off the level of the Fed’s previous tantrum (the autopilot one) at the end of 2018. Stocks had also sold off around 20% at that time. also.
Inflation should remain quite persistent. Therefore, while current yields are at attractive levels in our view, we shouldn’t expect the same kind of steady decline in yields that we saw in 2019. This suggests that investors may need to rest content with clipping. coupons rather than expecting outsized capital gains in the future.
One thing most investors can agree on is that short-term rates will continue to rise as the Fed tries to get inflation under control. The 3-month Libor has already risen to 2.15%, around 2% above its level at the start of the year.
However, what will happen to short-term rates once the Fed is expected to top its key rate next year is unclear. Historically, the Fed has only stayed at its maximum key rate for an average of 7 months. If inflation remains high, we could see short-term rates stay in a range. If inflation rises further, short-term rates should continue to rise. And if, as the Fed seems willing to do, the economy slips into a recession and inflation begins to subside due to lower demand, short-term rates should fall.
Market expectations are that Libor will peak around 3.5%, then decline to 2.8%, then range around that level for the foreseeable future. This expectation is probably less of a firm belief in the exact path of short-term rates, and more of a weighted average across a very wide range of expectations.
Interestingly, the majority of Libor-based Fix/Float preferred shares have a first call date sometime in 2024. In our view, there is a clear potential downside to these preferred shares.
Indeed, short-term rates are less likely to continue rising in 2024 as they are this year and next. In fact, as the chart above shows, the market consensus is that short-term rates are falling. The risk of recession is not negligible and if that happens, we could very well see a reversal of the Fed’s key rate hikes. This will reduce the coupon levels of preferred shares reset in 2024. This will also clearly reduce the coupon levels of preferred shares reset in 2022/2023, but at least those preferred shares will have benefited from a previous coupon increase, as they would have been reset to floating rates at an earlier date.
This means that investors who are overweight preferred shares reset in 2024 may be exposed to lower levels of income in the event of a hard landing without having reaped the benefits of rising short-term rates. In our view, it can be useful to diversify the timing of the move from floating rates to short-term resets, which we highlighted earlier.
Mortgage REIT Two Harbors Investment Corp (TWO) has announced authorization to redeem up to 5 million of its preferred shares (out of a total of 29 million A, B and C shares). This is good news for the favourites. We shouldn’t expect all 5 million to be redeemed – perhaps none will be purchased – but, at least, it demonstrates that the company is trying to maintain the quality of preferred shares by supporting their fund coverage clean. It’s also another example of how the interests of preferred stockholders, at least in this case, come before those of common stockholders.
The company previously backed the preferred shares by buying them back despite trading below “par”. They also issued additional common stock which backs the stock/preferred stock hedge.
The Q1 equity/preference hedge ratio for TWO favorites was 3.5x – not surprising, so it’s good to see that the company is potentially doing something to address this issue. It could also indicate that the book values of the mREIT agencies (AGNC, ARR, DX, NLY, etc.) are not good in the second quarter, since TWO has an 80% allocation to the agencies.
The silver lining for TWO is that its leverage is quite low at 4.7x among agency-focused mREITs. This is something that helped its book value to do reasonably well in the first quarter, i.e. a decline of 5.8% against declines of 15-16% for AGNC and NLY.
The Series A TWO 8.125% (TWO.PA) looks best in the sequel with a YTW of 9.1% until its first call date in 2027 – after which it floats at 3ml + 5.66% . We continue to hold the stocks in our high income portfolio.
Location and takeaways
This week, we picked the preferred short-term reset mortgage REIT Annaly Capital Management 6.95% Series F (NLY.PF) in two of our income portfolios. NLY.PF will soon benefit from the built-in rise in short-term rates given its reset to a floating rate coupon in September. It also exhibits a combination of modest leverage and high equity/preferred coverage in the agency-focused mREIT space. NLY.PF’s reset yield is 9.1%, ie its stripped yield should be this when it floats in September.