This article was first released to Systematic Income subscribers and free trials on Feb. 20
Welcome to another installment of our Preferreds Market Weekly Review where we discuss preferreds and baby bond market activity from both the bottom-up, highlighting individual news and events, as well as top-down, providing an overview of the broader market. We also try to add some historical context as well as relevant themes that look to be driving markets or that investors ought to be mindful of. This update covers the period through the third week of February.
Be sure to check out our other weekly updates covering the BDC as well as the CEF markets for perspectives across the broader income space.
It was a mildly positive week for the preferred space, supported by stability in long-term Treasury yields.
On a month-date basis most sectors remain down with the Tech sector outperformance driven by one convertible preferred due to the pop in its issuer’s common stock.
The drop in February now exceeds the January performance and brings year-to-date performance to around -4% for the space. Year-to-date only the Energy sector remains in the green.
In our CEF Weekly this week we explored the theme of tax-loss rotations and how investors can identify potential rotations that leave them with a broadly similar position while locking in some tax-losses to use against gains either now or potentially later in the year.
Preferred investors can do something similar. The task of identifying a similar kind of preferred is, in some way, much easier in the preferred space than in CEFs because preferred issues often issue multiple series which provides investors with the same credit profile. One key difference, however, is coupon structure is often different among the series which means that, while credit risk is the same, interest-rate risk may not be the same.
Specifically, when comparing different series to each other investors ought to focus on:
- current coupon level
- coupon structure ie fixed-rate or fix / float
- yield-to-worst ie the minimum of yield-to-call and the stripped yield
- reset yield ie the expected yield on the first call date of a fix / float security
Current coupon level is useful because lower-coupon perpetual securities feature a higher duration profile which can cause them to underperform during periods or rate rises
Coupon structure is useful because fixed and fix / float securities respond differently to changes in interest rates.
Yield-to-worst is a useful metric that captures both the yield investors would enjoy at the current price as well as any potential headwind in case of redemption.
Reset yield is useful because it tells investors what their yield is likely to be on current price for a fix / float stock that remains outstanding past its first call date. This is arguably the most complex metric to come to grips with because different stocks have different first call dates which makes comparisons difficult. The reason this is relevant is because the underlying floating rate such as Libor is likely to be different at different times which is the reason we use Libor forwards rather than current Libor to compare reset yields.
Let’s have a look at how this might work in practice.
We can use the New York Mortgage Trust (NYMT) preferred as an example. The 7% Series G (NYMTZ) has underperformed the rest of the suite year-to-date with a total return of around -10% – let’s see which other series could be potential rotation options.
NYMTZ is the sole fixed-rate preferred so investors looking for another fixed-rate mREIT preferred may have to look elsewhere – we like the (ARR.PC) and (CIM.PA) as alternatives. Investors happy to stay within the NYMT suite and hold a Fix / Float have the choice of 3 other series. Two of these (NYMTN) and (NYMTM) are Libor-based preferreds and (NYMTL) is a SOFR-based preferred.
At some point the Libor-based preferreds will likely be either redeemed and refinanced with SOFR-based preferreds (if the issuer wants to keep the floating-rate profile without going the Constant Maturity Treasury ie CMT route) or will be restructured into a SOFR- based preferred, possibly with a larger spread over SOFR, given SOFR, being a secured rate (ie backed by Treasury collateral), is likely to trade below Libor which is, in theory, an unsecured rate.
On a yield-to-worst basis (the minimum of stripped yield and yield-to-call), NYMTN offers the highest yield at 8.23%. However, NYMTM offers the highest reset yield based on Libor forwards ie based on what Libor is expected to be on the first call date. Staying with these two series we can summarize the choice facing investors as the following:
- NYMTN gives you a yield of 8.23% up to the first call date and if not redeemed on its first call date (ie stripped yield) in 2027 and an expected yield of 7.82% (ie reset yield) after its first call date. If redeemed on the first call date, NYMTN offers a yield of 8.63% (ie yield-to-call).
- NYMTM gives you a yield of 8.01% up to the first call date and if not redeemed on its first call date (ie stripped yield) in 2025 and an expected yield of 8.48% (ie reset yield) after its first call date. If redeemed on the first call date, NYMTM offers a yield of 8.54% (ie yield-to-call).
Investors who worry about the stocks not being redeemed (and a potential step-down in coupons) should stick with NYMTM as it offers a significantly higher reset yield which is, unusually, higher than its stripped yield. Investors who, on the other hand, want longer call protection may want to stick with NYMTN which has its first call date at the end of 2027 versus early 2025. At the moment we find both stocks attractive, however, occasionally NYMTM moves out to offer both a higher YTW and a higher reset yield at which point we would prefer NYMTM.
Some of the higher-quality CEF preferreds looks attractive again. These are good options for investors who tend to tilt to investment-grade rated preferreds but who also do not want to mainly hold bank preferreds.
Decent choices from Gabelli funds are all trading around at yields north of 5%. These are the GAMCO Global Gold Natural Resource & Income Trust (GGN.PB), trading at a 5.07% yield with asset coverage of 789% as of January. We also like the similarly named GAMCO Natural Resources, Gold and Income Trust (GNT.PA), trading at a 5.27% yield with asset coverage of 482% and the Gabelli Equity Trust 5% Series G (GAB.PG), trading at a 5.08% yield with asset coverage of 514%.
These preferreds have a number of advantages over other CEF preferreds. First, they have enormous asset coverage – much higher than other CEF preferreds. Secondly, they are more intuitive for investors to understand as they hold stocks – a lot of which are household names, rather than say, convertible debt or CLO Equity. Thirdly, their issuing funds typically have very low levels of leverage – by contrast fixed-income CEF preferreds typically operate at leverage above 30%. Fourthly, they do not have any debt ahead of the preferreds in the capital structure which would be first to get paid off or bought back in the market in case of distress unlike many fixed-income CEF preferreds. Finally, all of the stocks mentioned are trading a bit below “par” and, given Gabelli have been regularly redeeming their preferreds, this may result in a small additional return tailwind in case of redemption.
To provide some intuition here, if GNT (which has the lowest asset coverage of the 3 funds mentioned) assets drop by 79%, the preferreds will still be fully covered by assets. The funds do hold stocks and they are leveraged but for the preferreds to be “impaired” we are talking about something worse than the GFC to push fund assets below the level of the preferreds. It’s also important to point out that during the GFC the Gabelli funds were redeeming the preferreds to deleverage which is great because it supported their price and improved their asset coverage so even if we see something like the GFC the preferreds should still be OK because Gabelli will be buying them back and / or redeeming them. Traded volume on all of these is pretty low so they require patience to acquire.
There was a discussion on preferred flows on the service chat. Retail preferred flows tend to be more volatile and can push around funds with larger retail holdings such as (PFF), (PGX) and others. One way to mitigate the impact of retail flows is to hold something like (FPEI) which holds institutional preferreds. For instance, FPEI is down 3% YTD while PFF is down 9%. Another source of support for FPEI is that institutional preferreds are mostly fix / float so their prices should be supported in the current environment where short-term rates have been rising rapidly.
A number of mREITs – a sector whose preferreds we are overweight in our Income Portfolios – reported Q4 results this week.
Chimera Investment Corp (CIM) book value fell around 4% which partly offset an 8% Q3 gain. Equity / preferred coverage remains fairly high at 4.0x (lower by 0.1x) and recourse leverage ticked lower to 0.9x from 1.0x. GAAP leverage looks high at 4.0x however GAAP leverage ignores the difference between recourse and non-recourse leverage. CIM has most of its leverage via securitized debt where investors do not have recourse to CIM itself but only to the portfolio of assets in the securitization vehicle. This means if the individual vehicle goes bust debt holders can not come after CIM unlike in, say, a repo or a credit facility. This is a big plus for preferred holders.
CIM managed through 2020 fairly well with no margin call issues or dividend suspensions and its reliance on securitized debt is now much larger than it was in 2020 and, partly for this reason, its recourse leverage is much lower. The agency allocation has been reduced as well in favor of whole loans so there is a trade-off there.
Overall, the preferreds remain attractive. They are down 2-3% year-to-date which is a pretty good result given the price action in the higher-quality preferreds and CEFs. (CIM.PA) is an attractive fixed-rate series trading at a 8.09% yield which is also supported by the fact it is currently callable while (CIM.PB) is attractive as a fix / float security with a 8.16% YTW and a 7.75% reset yield based on Libor forwards with respect to its 2024 first call date. NYMT book value fell about 1%, recourse leverage rose to 0.4x from 0.3x and equity / preferred coverage remains the same at 4.2x. As discussed above, we continue to like both the (NYMTN) and (NYMTM) at current prices, offering yields north of 8%. Both are fix / float issues with 2027 and 2025 first call dates. Invesco Mortgage Capital (IVR) numbers were updated as well. IVR are the highest-yielding agency-focused preferreds and yet have never been particularly attractive. Book value was down more than 10% in Q4 despite relatively low leverage (and another 10% lower in January). The combination of low equity / preferred coverage at 3.2x as of Q4 and management that appears to be flamboyantly incompetent are key question marks. At least when TWO faceplanted in 2020 they internalized management – IVR had an even worse experience and do not appear to have done much at all apart from reducing their non-agency holdings.
Generally speaking, management competence is less relevant for preferreds than it is for common shareholder results, especially when the preferreds are protected by sizable coverage. However, IVR has one of the lowest preferred coverage levels which gives it a lower margin of safety. TWO preferred at a similar yield look more attractive eg TWO-A at a 8.14% yield-to-worst (with a reset yield of 7.58% based on Libor forwards with respect to its 2027 first call date).
Stance & Takeaways
We continue to find value in shorter-maturity preferreds, particularly given the uncertainties around the persistence of inflation and the path of longer-term interest rates. For instance we like the mREIT AAIC 2025 bonds (AIC) trading at a 6.81% YTM, BDC OXSQ 2024 bonds (OXSQL) at a 6.44% YTM and CEF ECC 2029 bonds (NYSE: ECCV) at a 6.09% YTM. The presence of a maturity date will tend to anchor these senior securities relative to their perpetual counterparts, all else equal.