The current market environment feels particularly uncertain for income investors with respect to the path of interest rates, inflation, Fed actions and other key issues. The preferred stock space offers investors ways to both diversify across these potential developments as well as express their views on market outcomes. In this article, we discuss different types of payoffs of preferred stocks, ranging from fixed to floating-rates, callable vs. non-callable, perpetual vs. term-dated, pinned-to-par vs. not and others. The key takeaway is that different preferred structures offer different exposure and risk/reward to investors which can be used to both diversify risk and express individual market views, something that is not possible via allocations to funds.
Longer-Term Floating Base Rates
The majority of retail preferred stocks are fixed-coupon which makes them more vulnerable to increases in interest rates than fixed-to-float stocks. Fixed-to-float preferreds offer different floating base rates to investors such as SOFR, 3M LIBOR and different Treasury tenors. The Athene (ATH) preferreds make for a nice petri dish for seeing how different payoffs respond to changing market conditions. The four Athene preferreds are the following:
- Athene 5.625% Series B (ATH.PB) and 4.875% Series D (ATH.PD) are both fixed rate
- Athene 6.35% Series A (ATH.PA) floats at 3mL + 4.253% after 2029
- Athene 6.375% Series C (ATH.PC) floats at 5yCMT + 5.97% after 2025
The chart below shows how the different series have reacted to a period yield curve steepening over the last few months. For instance, 5y Treasury rates have risen about 0.5% since the start of the year while shorter-term rates have gone nowhere, given the anchor provided by the Fed policy rate which is expected to be on hold for a couple of years.
Source: Systematic Income
As expected, ATH.PC, which is linked to the 5y Treasury rate, has outperformed the other 3 preferreds. Interestingly, the market has completely panned the Libor-linked series, which underperformed during the period of spiking rates at the end of March. This highlights the silliness of recommendations that pitch floating-rate assets tied to short-term rates as bound to outperform in a rising rate environment.
With respect to the Athene preferreds, our own view is that ATH.PC has rallied a bit too much as it is trading 13% above “par” with a YTC that is 1-1.5% below that of the other series. In other words, ATH.PC is not actually expected to take advantage of the very attractive potential reset rate as it will probably just be redeemed on the first call date. That said, this example highlights that preferreds with reset rates linked to the belly of the curve that is not anchored by the Fed policy rate, can outperform during worries about inflation and rising interest rates.
An important point here is that not all CMT (or constant maturity Treasury) resets are created equal. There are some stocks that were issued a while back when Treasury yields were significantly above current levels which caused their spreads over the floating-rate to be set at low levels. This means that at current Treasury yields the coupons of these stocks will reset lower than their current fixed coupons. An example here are the Enbridge (ENB) preferreds so investors have to keep this in mind that not all CMT resets are equally attractive.
Recent issuances with attractive floating spreads over 5y CMT are the Textainer Group Holdings Series A (TGH.PA) at 5y CMT + 6.134% which compares favorably with its 7% fixed coupon, trading at a 5.83% YTW. Another is the WesBanco 6.75% Series A (WSBCP) with a 5yCMT + 6.557%, trading at a 4.27% YTC and rated BBB- by Kroll, for what it’s worth.
The takeaway here is that investors who are worried about interest rates in the belly and longer-end of the yield curve continuing to rise should have a look at fixed-to-float preferreds with CMT resets, particularly those featuring attractive reset yields at current rates.
Because institutional preferreds are predominantly fixed-to-float and actively-managed preferreds funds are mostly allocated to institutional preferreds, investors who use preferreds CEFs or mutual funds will likely be very overweight fixed-to-float stocks. For example, the First Trust Intermediate Duration Preferred & Income Fund (FPF) which is the only preferreds CEF to our knowledge that discloses its allocation to fixed-rate vs. fixed-to-float vs. floating-rate preferreds shows that its allocation to fixed-rate stocks is less than 20%. What this means is that investors in these funds may be unwittingly exposed to the risk of lower reset coupons (if the floating-rate coupon is below the fixed-rate coupon which would incentivize the issuer to keep the stock outstanding) or to redemptions (if the floating-rate coupon is above the fixed-rate coupon which would incentivize the issuer to redeem the stock to avoid paying a higher interest rate).
The trend in the retail preferred space has been to issue fixed-to-float preferreds which also limits the playing field somewhat. However, with interest rates trading at relatively low levels across the curve, particularly earlier in the year, some issuers like Bank of America, Schwab, Athene, US Bancorp and others have taken advantage of this and issued fixed-rate preferreds.
The Schwab 4.45% Series J (SCHW.PJ), rated BBB/Baa2 at a 3.95% yield and a 2026 call date looks reasonably priced. A1-rated RiverNorth/DoubleLine Strategic Opportunity Fund 4.375% Series A (OPP.PA) at a 4.57% yield and a potential kicker in case of open-ending of the parent CEF looks attractive also.
The takeaway here is that investors who are worried about a lower for longer interest rate regime may want to look at fixed-rate preferreds with longer call protection periods.
The big advantage of non-callable preferreds is, very simply, that they cannot be redeemed by the issuer. This may be attractive for investors who want to lower the risk of redemption, particularly in the current environment where redemptions have been coming hard and fast as issuers take advantage of high preferreds prices to refinance at lower coupons.
Source: Systematic Income Preferreds Tool
The other attraction of non-callable preferreds, which is often missed, is that they maintain their upside in case of lower rates which callable preferreds don’t. In other words, if rates move lower, non-callable fixed-rate preferreds prices will continue to rise (e.g. WFC-L is trading 50% over “par”, for example) while callable preferreds will tend to stabilize only a few percentage points above “par”. This higher upside is not readily observable in the yields that investors use to make their allocations because calculating option-adjusted yields is model-specific and not a market-standard. So, a 5% stripped yield (also called YTP or yield-in-perpetuity on a non-callable preferred) is much more attractive than a 5% yield-to-worst on a callable stock, all else equal. In effect, the “same” optical yield of the perpetual stock is in reality higher once adjusted for the embedded option that the investor is short in the redeemable stock.
Within the non-callable space, we continue to like the Southern California Gas 6% Series A (SOCGP), rated BBB+ / Baa1 (and A- by Fitch) with a 4.3% yield. We also like the A. Schulman, 6.00% (SLMNP), trading at a 5.65% yield, which is now neither A. Schulman nor convertible. Rather, it is a former A. Schulman convertible which lost its convertibility on the merger and is now a preferred of an LYB subsidiary. LYB has a standing tender offer at around 80% of par which is worth quite a bit as LYB is investment-grade. Some commenters have suggested that this is akin to having an 80% investment-grade secured loan and a 20% investment-grade preferred which isn’t quite right. A guarantee from LYB is not a secured loan as a guarantee is unsecured so it’s more like unsecured debt (which is still IG-rated and so very attractive) and the 20% IG preferred is not really IG since it’s a subsidiary preferred of an IG issuer which is itself unrated. LYB could let the subsidiary go in a crunch – it doesn’t have to bail it out.
The takeaway here is that investors who want to minimize the risk of losing their coupon streams due to redemptions should have a look at non-callable preferreds.
Pinned-to-par securities are those that are currently callable and are trading at or above their redemption amounts. These securities have two primary attractions. First, they are slightly less sensitive to rising interest rates due to their wider credit spread cushion. In other words, it takes a larger rise in interest rates to push down the prices of pinned-to-par securities, all else equal. This doesn’t make them immune to higher rates but for small rises they shouldn’t move as much.
The second benefit of pinned-to-par securities, which is very much related to the first benefit, is that these securities trade at higher yields than they “should”. This has to do with a pure mechanical fact that investors are not willing to bid up the price of a redeemable stock significantly past its redemption price, lest they be stuck with a loss in case of a redemption. This price stickiness around the redemption price (which is usually “par”) causes the yield to remain elevated.
The obvious downside of these securities is that they can disappear in short order since the market is signaling to the issuer that the coupon they are paying on the stock is higher than what the market demands. One way to mitigate this is to choose lower-coupon series of the issuer though this is not foolproof as we have seen recently with Two Harbors and TDS which redeemed multiple securities in one go.
Legging into these securities takes some care, particularly, those with negative yields-to-call worse than -1% (the typical 30-day notice period should normally leave investors with no loss at around a negative 0.5% YTC, depending on the coupon).
Currently, we are keeping an eye on US Cellular 6.95% 2060 baby bonds (UZA) which has a 6.82% YTM and a -1.7% YTC (ignoring the notice period). This bond is behind UZC in its coupon which is more likely to be redeemed first. The 7.25% UZB was recently called.
The takeaway here is that investor can earn a higher yield than they “should” due to the pinned-to-par effect of many preferreds due to the fact that issuers often take their time to redeem existing series.
One disadvantage of preferred securities is that the vast majority are potentially perpetual which exposes investors to significant interest rate risk. Higher interest rates will make it uneconomic for issuers to redeem their preferreds, leaving investors with both capital losses and relatively low-yielding holdings. Even baby bonds may not come to the rescue here despite the fact that nearly all have maturities as their maturities tend to be extremely long.
One sector which features senior securities with shorter maturities is the CLO CEF sector. For example, the Priority Income Fund 6.375% Series E (PRIF.PE) has a 2024 maturity and is trading at a 6.51% YTM (and a higher YTC, being below “par” in clean price terms).
We also like the OXLC 6.75% 2031 bonds (OXLCL) with a 2031 maturity, trading at a 6.43% YTW.
The takeaway here is that investors can potentially immunize themselves against higher interest rates by allocating to term-dated preferreds and bonds.
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