Preferences Market Weekly Review: Checking Forward Yields

Business charts on a screen

da-kuk/E+ via Getty Images

This article was first published for Systematic Income subscribers and free trials on March 19.

Welcome to another installment of our Weekly Preferences Market Review, in which we look at baby bond and preference market activity both from the bottom up, highlighting individual news and events, and from the top down, providing an overview. of the market in general. We also try to add some historical context as well as relevant topics that seem to be driving the markets or that investors should be aware of. This update covers the period up to the third week of March.

Be sure to check out our other weekly updates covering the BDC and CEF markets for insights into the broader revenue space.

market action

All preferred sectors rebounded this week with the preferred average up more than 1.5%. However, so far this year, all sectors remain in the red.

average preference bar chart

Systematic Income

This strong weekly performance recovered all losses during the month and now March is shaping up to be flat as a pancake.

Preferred Industry Average Monthly Performance Bar Chart

Systematic Income

The preferred average has generated close to zero returns over the past year, which is not too bad given the price action we have seen so far this year.

Preferences 1 year of mobile total return

Systematic Income

A year of stagnation (as a whole) is clearly a disappointment for many investors. On the plus side, however, this short-term pain sets up income portfolios for long-term gains because it allows investors to reinvest dividends at higher yields, as well as deploy drier assets in more attractive positions.

market themes

If we were to describe a particular investment product with a coupon that can change based on market forces, with a potentially unlimited shelf life, and with built-in call options, many investors would think we were talking about some kind of highly complex institutional derivative. However, we have just described a fairly basic preferred stock. Although preferreds are very popular with individual investors, it does not make them less complex instruments. This complexity is particularly relevant now that Libor, the base rate for most preferred fixed/floating rates, has begun to lift off in anticipation of a sequence of Fed policy rate hikes.

This, coupled with the fact that 1) many preferreds will soon reach their first call date and thus the start of their floating coupon periods and 2) many will not redeem as their coupons will be reduced, highlights the fact that investors should start thinking seriously about the returns on their fixed/float holdings after the end of the hold period.

The chart below compares the current fixed-rate coupons to the Libor-based reset coupons of these stocks. Restart coupons are basically derived from Libor futures or market expectations of Libor on the first call date. For example, a stock with a fixed coupon of 6.5% today that changes to a coupon equal to 3-month Libor + 4% at the end of 2022 and is trading at $24 will have a reset yield of 6.19% as it is expect Libor to be around 1.94% by the end of the year.

What is clear is that the vast majority of equities will most likely see a reduction in coupons based on current Libor market expectations. Of course, it’s possible that 1) some of these shares will be redeemed or 2) Libor will beat current market expectations, but as things stand now, we expect most of the shares to remain outstanding given the reduced coupons. and a difficult situation. refinancing environment for issuers. The chart below compares the current and reset coupons of Libor Fix/Float shares that are expected to change to a floating rate coupon within the next two years.

chart comparing current and reset coupons of Libor Fix/Float shares

Systematic Income

What can investors do? One option, as always, is to do nothing. It is not entirely unreasonable to say that the expected reduction in coupons is more or less priced into the markets today and that the higher yields to the first purchase date of the Fix/Float preferreds are simply a kind of compensation for a lower performance to come.

For example, we can see this by comparing the worst-case performance of four preferred CIMs, one of which is fixed-rate (CIM.PA) with the other three Fix/Float. The fact that all three Fix/Float stocks are trading at higher yields through their purchase date than CIM.PA could just be a reflection of the fair value of their next decline in yields. In short, investors are compensated today for the likely drop in performance that will occur in the future, leaving them squared.

MIC yields

Systematic Income

We sympathize with this argument, however, we are also of the opinion that the market for broader preferences is not as universally efficient as this example might imply. Specifically, there are opportunities between Fix/Float preferreds from the same issuer, as well as between Fix/Float series between issuers.

Let’s see how investors can identify these opportunities. Let’s use the three NLY preferences as a case study: they are summarized below with a screenshot of our investor preferences tool.

case study of three NLY preferred

Preferred Systematic Income Tool

Now let’s plot, what we call, the forward returns of these stocks against each other.

returns relative to term

Preferred Systematic Income Tool

This is how term yields work. Until the date of the first call (marked with a black dot), the performance of a given stock is only the worst performance. Worst Yield is the minimum of reduced Yield and Yield to First Call, a fairly standard way of handling the yield of a security due to its first call date.

for example, for NLY.PFthe adjusted return is 7.2%, while the demand return is 14.1%, so the worst return is 7.2%.

After the first purchase date, the return on the stock is just the expected Libor (i.e. forward Libor) on that date plus the spread over Libor, divided by the stripped price, i.e. clean x the preference settlement. For example, the reset yield of NLY.PF on its first call date 30-Sep-22 is (Libor forward 1.62% + spread over Libor 4.993%) / current stripped price of $24.07 x preference Settlement $25 = 6.87%.

Each subsequent quarter, the coupon will change based on the evolution of Libor futures, which looks like the following as of this writing. Libor forwards are updated daily like “normal” or par interest rates do, as they are just a function of current interest rates. Geeks in the audience can learn all about starting advance rates here.

Libor futures chart

Preferred Systematic Income Tool

If we go back to the chart, we see that, except for the initial point lower on its first call date, the forward yield of NLY.PF tends to trade above the yields of the other two series, so it is the series that seems most attractive to us.

There is a slim chance of a swap on the first call date and it is something investors should keep in mind, however even here NLY.PF looks near the best. NLY.PF has less call protection, however in our opinion it is quite likely to remain in circulation beyond its first call date and apparently given its sub-par price this is what the market also waits.

Obviously, investors may have a different view of Libor’s path than the market implies, but a comparison of forward yields such as the one described here is a good starting point.

market comment

Sachem Capital recently issued new 6% 2027 bonds (SCCE). The company provides secured loans to real estate investors for the purpose of acquiring, renovating or developing properties, a decent business at the moment but quite dependent on house prices holding up well and which may come under pressure as the Fed continues to hike. /reduces MBS on the balance sheet.

Asset coverage of the roughly $160 million in bonds appears relatively thin, about twice as large, with a $30 million credit facility ahead of the bonds. That said, some of the shorter-maturity bonds don’t look too bad. Within its suite, SACC (currently callable, trading at 6.7% YTM) seems reasonable as it is less likely to be redeemed immediately as it has a lower coupon than 2 other bonds that are currently or will be callable early. SACC has a fairly short maturity at the end of 2024, so there is better visibility to that date than SCCE’s Q1 2027. Three of the company’s bonds are in the green so far this year, highlighting once again that par/shorter maturities fixed can hold up well in a period of rising rates.

Posture and takeaway

The 3-10 Treasury yield curve has continued to flatten decisively as short-term rates have risen faster than long-term rates. For example, the 3s10s portion of the curve has already inverted, while the closely watched 2s10s are within 0.17% of the inversion.

Treasury yield curve

Preferred Systematic Income Tool

This strong flattening means that longer-duration instruments now offer much less of a yield boost than they did historically, making them less attractive relative to shorter-duration instruments such as senior time securities (i.e. those with expiration).

For this reason we continue to find value in mREIT AAIC 6.75% 2025 Notes (AIC) trading at 6.76% YTM, CEF Eagle Point Credit 5.375% 2029 Notes (ECCV) trading at 6.28% YTM and BDC OXSQ 6.5% 2024 Notes (OXSQL) that have held up well so far this year.

Previous post 4 reasons to sell your house before you stop working
Next post There are no advantages in a meeting at 8 am
%d bloggers like this: