Despite the recent rise in Treasury yields, the yields of many preferred stocks are trading close to their historic lows. There are still pockets of value in the market; however, they are often linked to not run-of-the-mill stocks. In this article, we take a look at some of these special or complex cases which continue to offer an attractive combination of risk and reward.
One of the most basic decisions investors in preferred stocks can make is to allocate to a fund or to individual preferred stocks. We discussed in an earlier article the widening gap between stripped yield and current yield and the fact that active preferreds funds tend to lean to higher income at the expense of holding low yield-to-call preferreds. Passive funds often ignore valuation altogether and buy whatever is in the index.
Source: Systematic Income Preferreds Tool
Allocating to individual preferreds not only allows investors to be fully aware of the true yield their capital is earning, but also to manage their sector profile. This is because most preferreds funds tend to hold outsized exposure in the financials sector and, while we view the sector as relatively high-quality, it has two downsides: first, it, obviously, overweights what is a relatively leveraged and cyclical sector and secondly, it tends to earn relatively low yields as the financials sector tends to be higher-quality than the rest of the preferreds market.
For investors who are happy to remain allocated to financials like banks which have a big footprint in preferreds funds, there is a wide variety of yields on offer. For example, the screenshot below shows the yield-to-worst of the various Bank of America preferreds, highlighting that the BAC 7.25% Series L (BAC.PL) remains the highest-yielding of the bunch. This series is convertible (into $1300 worth of the common); however, the common has another 60% to go and investors who are worried about that outcome can hold a small amount (roughly 10% of the dollar amount of the preferred shares held) of the common as a hedge.
In fact, the yield advantage of BAC.PL is understated since its lack of a redemption feature means it doesn’t suffer from the negative convexity and limited upside of the other series.
Source: Systematic Income Preferreds Tool
The retail preferreds market features a number of what we call bond repacks or, more formally called, structured products. KTBA is a Salomon Smith Barney CorTS or a corporate-backed trust security – a type of structured product. In more colloquial terminology, this is a bond repack where an investment bank takes a particular bond, sticks it in a bankruptcy-remote special purpose vehicle, often adding a few bells and whistles on top, such as a different currency denomination or a different coupon type (switching fixed to floating or vice-versa) or embedded calls which also allows it to also take out fees in the process. In this particular case, this is a very simple repack where the SPV or Trust simply pays out the coupons it receives on the underlying Investment-Grade-rated BellSouth 7% 2095 bonds which were subsequently acquired by AT&T (NYSE:T). It looks like the bank took out at least 3% in fees when structuring the security – it’s not clear where the bond was trading at the time it was structured but it must have been below par. In any case, the point of the repack is to allow retail investors to own the risk of a corporate bond which they otherwise would not be able to access.
What is interesting about KTBA is that the bond is trading at around a 4.76% yield while KTBA itself is trading at a 5.83% yield. Not only are investors getting a pick-up on what looks like the same risk, but a near-6% yield on investment-grade security is hard to find, even if the maturity is extremely long (though it’s not perpetual). This preferred is non-QDI (as is the underlying bond) and maybe best held in a tax-sheltered account due to a weird tax angle that may cause any capital gains to be taxed at a short-term rate.
Capital Structure Relative Value
Many issuers have both debt and preferred securities which offer attractive relative value opportunities for income investors and whose differences are not fully appreciated by the market.
One example we have discussed is the Oxford Lane Capital Corp. (OXLC) capital structure. OXLC has issued both baby bonds and preferred stocks. The recently issued OXLC 6.75% 2031 bonds (OXLCL) are trading at a similar or higher YTC than the preferreds of the same issuer. OXLCL bonds have longer maturity than the preferreds but on a duration basis, they are not actually very far away from the preferreds. This is because all the OXLC senior securities are trading around par and so have a relatively high probability of being redeemed long before their legal maturity which is what happened to OXLCO.
The upshot here is that the market is not fully appreciating the fact that the preferreds are behind the bonds in the capital structure and only get paid once the bonds are fully repaid. We continue to favor OXLCL over the OXLC preferreds.
Gladstone Land (LAND) is a REIT that owns farms, farm mortgages and farm real estate. Though the company looks to be operating with a negative net income, the NAV coverage of preferreds is around 2.8x (this is valuation of farms, mind you). They have unusually structured preferreds as well as an unusual way of placing them. What they do is offer them out to the public and only list them on an exchange about a year after. The same thing happened with Series B which now trades under the ticker LANDO. Series C is offered now on the myipo.com website at $25 at a 6% coupon. It is a bit surprising they are offering Series C at 6%/$25 even though Series B (aka LANDO) is also a 6% stock and trading at $25.74 clean price. At the moment you could argue that LANDO should trade at a higher price due to its liquidity premium (you can sell LANDO on the exchange while you can only sell Series C back to the issuer at $22.50). However, that liquidity premium has an expiration date on it so the closer we are to the listing of Series C the lower that premium will be and the 3% price differential between the two series should converge.
Preferred stocks are divided, broadly speaking, into retail and institutional preferreds. Retail stocks tend to be traded on an exchange and feature a ticker while institutional preferreds trace OTC via cusips/ISINs and have no ticker. The preferred CEFs, well-known to income investors, mostly hold institutional preferreds. To transact in individual institutional preferreds requires registering as an accredited investor which itself requires passing an income or asset test. This means this is not a strategy that will work for the majority of income investors – in short, investors who are willing to put in the work of transacting in these securities and who have an adequate portfolio may find this strategy appealing.
Institutional preferreds have a number of attractive features – they tend to have longer call dates than retail preferreds with many stretching close to a decade which offers greater call protection for investors.
Secondly, they tend to be fix-to-float with many featuring floating-rate indices in the belly of the yield curve e.g. 5-year Treasury or Interest Rate Swap benchmarks rather than the 3M Libor which is more prevalent in the retail space. This is relevant because the front end of the yield curve is likely to remain well-anchored around zero for the next few years by the Fed while the belly of the curve, e.g. 5-7 year points are more free to rise due to potential or real inflationary pressures. For example, over the last few months, 5-year Treasury yields have risen from 0.3% to near 0.9% while 3M Libor has remained at around 0.2%. The rise in Treasury bond yields doesn’t necessarily mean that investors will enjoy these rates since most institutional preferreds are likely to be redeemed at the first call date but it does mean that their prices are likely to be better supported if rates remain where they are or continue to rise (because reset yields of many institutional preferreds are above their current stripped yields).
The screenshot below from our Preferreds Tool captures some of these key dynamics. It shows six Huntington Bancshares (HBAN) preferreds: three retail (with tickers) and three institutional (with cusips).
Source: Systematic Income Preferreds Tool
Two of the three retail preferreds are currently callable and are trading at negative YTC. This highlights the fact that many retail preferreds are unattractive due to the combination of no call protection and negative yields-to-call. Two of the three institutional stocks have CMT floating-indices and higher reset yields than their stripped yields – which would be unusual in the retail space. This combination of longer call protection, high reset yields and more rational pricing is fairly common in the institutional space and is what makes it attractive to some income investors.
With easy money having been made in the run-of-the-mill preferreds space, an attractive combination of risk/reward is harder to come by. Investors willing to dig a bit further, however, may be rewarded by valuations that remain attractive in this market environment.
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