These Soon-To-Reset Preferred Stocks Pass Fed Rate Increases To You

One of the most dramatic repricings we have seen this year is the rise in short-term rates. Over the past 6 months, the 2Y Treasury yield rose from 0.27% to 2.71% as of this writing. This development has much to do with inflation that has remained more persistent than expected and the Fed that has turned more hawkish than expected.

The direct market outcome has been for expectations of Libor to continue to rise sharply from around 1.2% right now to around 3.4% about 18 months from now.

3M Libor forwards

One way to take advantage of the sharply rising short-term rates is to tilt to preferreds that will soon switch to floating-rate coupons if unredeemed.

The chart below captures a number of key yield metrics for stocks with less than 9 months to their first call date. The stripped yield is the familiar metric of the current coupon dividend by the stripped price. The reset yield is the expected stripped yield on its first call date if unredeemed (and based on the Libor forward on that date – see the chart above). The LT reset yield stands for long-term reset yield and stands for the stripped yield at the longer-term expectation of Libor which today is around 2.6%.

Preferred stock yields

The key point is that reset yields (or LT reset yield) of all the stocks are higher than their current stripped yields. This can allow investors who are keen to get on the Fed hiking trajectory bandwagon to potentially take advantage of rising short-term rates. These stocks may also be especially attractive for those investors who think the market is underpricing the ultimate level of inflation as well as the ultimate endpoint of the Fed policy rate. The reset yields in this scenario will be even higher than the figures in the chart above.

What if these stocks get redeemed? Since all of them trade at a stripped price at or below their “par” most will get a significant windfall in case of redemption. This also signals that the market expects redemption likelihood to be relatively low.

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