Favorite Weekly Market Review: Mastering Futures Yields
This article was first published to Systematic Income Subscribers and Free Trials on March 19
Welcome to another installment of our weekly preference market review where we discuss activity in the preferred bond and baby bond market both from the bottom up, highlighting individual news and events, as well as top to bottom, providing insight into the broader 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 third week of March.
Be sure to check out our other weekly updates covering BDC as well as CEF markets for insights across the entire revenue space.
All preferred sectors rebounded this week with the preferred average up more than 1.5%. Since the start of the year, however, all sectors have remained in the red.
This strong weekly performance recouped all of the month’s losses, with March now looking like a pancake.
The average preference has generated near-zero returns over the past year, which isn’t too bad considering the price action we’ve seen so far this year.
A year of stagnation (in total) is clearly a disappointment for many investors. On the positive side, however, this short-term pain creates income portfolios for longer-term gains, as it allows investors to reinvest dividends at higher yields and deploy drier assets into more attractive holdings. .
If we were to describe a particular investment product as having a coupon that can vary with market forces, having a potentially unlimited lifespan, and having built-in call options, many investors would think we’re talking about some sort very complex institutional derivative. However, we have just described a fairly basic preferred stock. Although preferred shares are very popular with individual investors, this does not make them less complex instruments. This complexity is particularly relevant now that the Libor – the base rate for most Fix/Float prime securities – has started to take off in anticipation of a string of key rate hikes from the Fed.
This, along with the fact that 1) many preferred stocks will soon reach their first call date and hence the start of their floating coupon periods and 2) many will not be redeemed as their coupons will withdraw, points out the fact that investors should start thinking seriously about the returns of their Fix/Float holdings after the end of the no-call period.
The chart below compares the current fixed rate coupons to the reset Libor based coupons of these stocks. Coupons reset are primarily derived from Libor futures or market expectations for Libor on the first call date. For example, a stock with a fixed coupon of 6.5% today that changes to a coupon equal to 3-month Libor + 4% at the end of 2022 and trades at $24 will have a reset yield of 6.19% since the Libor should be around 1.94% by the end of the year.
What is clear is that the vast majority of equities will most likely see lower coupons based on current Libor market expectations. Of course, it’s possible that 1) some of these shares will be repurchased or 2) that Libor will exceed current market expectations, but as things stand, we expect most shares to remain outstanding given falling coupons and a tough time. refinancing environment for issuers. The chart below compares the current and reset coupons of Libor Fix/Float shares which are expected to switch to a floating rate coupon over the next two years.
What can investors do? One option, as usual, is to do nothing. It is not entirely unreasonable to say that the expected lower coupons are more or less priced into the markets today and that the higher yields up to the first call date of the Fix/Float Preferred Shares are simply a kind of balancing of a lower yield to come.
For example, we can see this by comparing the worst-case yield of four preferred CIMs, one of which is fixed rate (CIM.PA) with the other three Fix/Float. The fact that the three Fix/Float stocks are trading at higher yields until their redemption date than CIM.PA could simply reflect the fair value of their next drop in yields. In short, investors are compensated today for the likely drop in yield to come in the future, net net leaving them square.
We support this argument, however, we also believe that the broader preferred stock market is not as universally efficient as this example might suggest. Specifically, there are opportunities between Fix/Float preferred shares of the same issuer as well as between Fix/Float series between issuers.
Let’s see how investors can identify these opportunities. Let’s use the three NLY favorites as a case study – they’re summarized below with a screenshot from our Investor Preferences Tool.
Now let’s plot what we call the forward yields of these stocks against each other.
This is how forward yields work. Until the first call date (marked with a black dot), the performance of a given stock is only the worst case performance. The worst case yield is the minimum of the stripped yield and the first call yield – a fairly standard way of managing the yield of a callable security until its first call date.
For example, for NLY.PF, the stripped yield is 7.2% while the call yield is 14.1%, hence the worst-case yield is 7.2%.
After the first call date, the stock’s return is just the expected Libor (i.e. the forward Libor) on that date plus the spread over the Libor, divided by the stripped price, c i.e. own price x liquidation preference. For example, the reset yield of NLY.PF to its first call date 30 Sep 22 is (Libor forward 1.62% + Libor spread 4.993%) / current stripped price $24.07 x liquidation preference of $25 = 6.87%.
Each subsequent quarter, the coupon will change based on the movement of Libor futures, which looks like the following at the time of this writing. Libor futures are updated daily, as are “normal” or par interest rates, as they are only a function of current interest rates. Geeks in the public can learn all about priming forward rates here.
If we go back to the chart, we see that except for the initial decline on its first call date, the NLY.PF futures yield tends to trade above the yields of the other two series, c That’s why it’s the series that seems the most appealing to us.
There is a small chance of redemption on the first redemption date and this is something investors should keep in mind, however, even here NLY.PF looks close to the best. NLY.PF has less call protection, however, in our opinion, it is quite likely to remain in circulation beyond its first call date and, it seems, given its price lower than “par”, this is also what the market expects.
Obviously, investors may have a different view of the trajectory of Libor than the market is implying, however, a comparison of forward yields as we have described here is a good place to start.
Sachem Capital recently issued new 6% 2027 bonds (SCCE). The company provides secured loans to property investors with the aim of acquiring, renovating or developing property – a decent business at the moment but quite dependent on the good behavior of property prices and which could come under pressure then as the Fed continues to hike/cut MBS on the balance sheet.
The asset coverage of the roughly $160 million in bonds looks relatively thin, at around 2x, with a $30 million line of credit before the bonds. That said, some of the shorter-dated bonds don’t look too bad. Within their suite, SACC (currently callable, trading at 6.7% YTM) looks reasonable as it is less likely to be called immediately, having a lower coupon than 2 other bonds that are currently or soon to be called . SACC has a fairly short deadline at the end of 2024 so there is better visibility on this date than SCCE’s Q1-2027. Three of the company’s bonds have been in the green year-to-date, underscoring, once again, that securities pinned at par/shorter maturity can hold up in times of rising rates.
Position and takeaways
The 3-10 year Treasury yield curve continued to flatten decisively as short-term rates rose faster than long-term rates. For example, the 3s10s part of the curve has already reversed while the closely watched 2s10s part is about 0.17% away from the reversal.
This strong flattening means that longer duration instruments now offer much lower yield recovery than before, making them less attractive compared to shorter duration instruments such as senior term securities (i.e. i.e. those with deadlines).
For this reason, we continue to find value in mREIT AAIC 6.75% 2025 (AIC) notes trading at 6.76% YTM, CEF Eagle Point Credit 5.375% 2029 (ECCV) notes trading at 6, 28% YTM and BDC OXSQ 6.5% 2024 Notes (OXSQL) which have held up well so far this year.