This article was first published to Systematic Income Subscribers and Free Trials on August 24th.
Welcome to another installment of our weekly Preference Market Review, where we discuss preferred bond and baby bond market activity both from the bottom up, highlighting individuals news and events, as well as top-down, providing an overview of the wider 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 August.
Be sure to check out our other weekly updates covering BDC as well as CEF markets for insights across the entire revenue space.
The favorites ended the week down along with almost every other income sector, as Powell clarified that the Fed was likely to keep rates higher for longer. As we recently pointed out, this was a significant risk for the market given the general view that the Fed would start cutting rates in 2023.
Retail preferred shares saw strong volume, as shown in the chart below for the largest preferred ETF (PFF). One-day volume this week was even higher than the strong sell-off in June. Institutional preferences, as represented by the PFEI, have not moved as much and the volume has been subdued. The highly volatile performance of the sector is keeping retail investors on their toes.
The recent rally in Treasury yields has hurt higher quality/low coupon stocks such as those in the banking and insurance sector.
The median return of the banking sector is no longer very far from a return level of 6%.
The spread over Treasuries has not increased as much and remains around 2.5%. A rise to a 3% level will make higher quality preferred shares very attractive in our view.
Overall, preferred stocks have given up some of their recent rally, but are not yet trading at the very attractive levels we saw in June, suggesting that investors don’t need to chase after stocks. actions in this limited environment.
There are many top-down allocation criteria that we have highlighted over the past year that are driving the performance of the preferred share sector. Besides typical credit quality and sector, important criteria include coupon/yield level (e.g., high or low), coupon profile (Fixed vs. Fix/Float), term vs. perpetual, pinned to even vs no and many more.
Preferred shares pinned at par are simply those that are currently redeemable or will become redeemable very soon by the issuer and trade around their liquidation preference (usually $25). This prevents the stock from rising well above $25, as this could result in an immediate loss for investors upon redemption. Because of this, the stock remains “pinned” at $25.
The term pinned at parity isn’t great though, as it implies that the stock is universally more resilient than stocks that are not pinned at parity. However, this is not the case. As we pointed out in the previous article,
… these titles are often locally resilient to higher rates and wider credit spreads. We say locally because, for sufficiently large rate hikes, the prices of these securities are not going to defy gravity and they will fall. But, for marginal increases in yields, they can maintain their resilience.
Preferred shares pinned at par can be locally resilient because these securities tend to trade at a higher yield than unpinned securities of the same issuer for the simple reason that their prices cannot rise for fear of redemption. This lower price (lower than it would be if not driven down by redemption risk) automatically translates into a higher return. This resilience lasts only as long as there is a yield cushion between it and other preferred shares of the same issuer. If market yields rise to the point where this cushion disappears, preferred shares pinned at par can break away very quickly and behave like any other preferred stock.
If we look at the year-to-date total returns of pair-pinned preferred stocks against their sectors, we see that they have indeed outperformed, but in many sectors that outperformance is marginal. This has a lot to do with our earlier comment that expected outperformance is mostly local, ie for small movements in returns. Once yields have risen sharply like they have this year, all bets are off. This marginal outperformance is explained by the time it takes for the return cushion pinned at parity to erode and this may indeed be a small market move.
Mortgage REIT Arlington Asset Investment (AAIC) completed the sale of 371 single-family properties (out of a portfolio of 586 valued at $182 million) for $130 million. This should increase book value by $0.50 per share or about 7% and increase equity/preference coverage to 6.3x from 5.9x.
This risk reduction, combined with very low leverage, a very high quality remaining portfolio (mainly agencies) and very high yields on preferred shares (AAIC-C at 9.8% yield stripped down to in 2024) and high yield on debt (AIC 2025 at 7.4% yield) makes it attractive.
Equity decreases as the company buys back shares (which remain well below book value) in order to return capital to investors. So it’s not ideal for preferred stocks or bonds, but it’s not critical.
There aren’t many mREITs that have generated a higher book value in the last 4 quarters (understanding that some of these are due to the non-payment of the common dividend, but even if a dividend had been paid , the book value would still have outperformed nearly all other mREITs).
That said, the AAIC is clearly a bit eccentric. They continue to not pay dividends on common stock, although on the call, Rock Tonkel mentioned that the board is considering reinstating it at some point. All in all, it’s still kind of a one-man Rock Tonkel band, which comes with some obvious risks.
Some links have been added to the Baby Bond Tool. Saratoga BDC’s 6% 2027 (SAT) bond is trading at a yield of 7.4%. With a maturity of 2027, it is quite attractive in the sector.
Prudential’s 2062 5.95% (PRH) bond is the most recent of their 3 bonds. With a yield of 5.8%, it is comparable to PRS and reasonably attractive for a premium issue. The very long 40-year maturity is an obvious risk – there are other shorter-maturity (albeit lower-rated) baby bonds at a similar or higher yield. That said, it still makes sense to have higher quality long-term options in the portfolio (remember the All-Weather concept) that can outperform in a typical recessionary type of market where credit spreads widen and Treasury bond yields fall.
Finally, the 8% 2027 bond (SCCG) – the latest bond from mREIT Sachem Capital – began trading just north of the 8% yield. He looks the most attractive of the sequel. Investors who want to shorten the duration further can opt for the 7.74% yield (SCCB) which is less than two years to maturity.