Rates Go Higher, Preferreds Pull Back, Opportunities Arise
Summary
Higher rates have caused a decline in the preferreds market creating some opportunities.
In a rising rate environment, focus on issues with limited duration, high coupons and ones that are pinned to par.
We review PRIF-E, RILYM, RCA, SCCC, CMO-E, CIM-A, NYMTO, ATCO-D, SESCF, GSLD, BSA, UMH-C, DX-B, and EBGEF.
RILYM and SESCF go ex-div 1/14.
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(This article was written on Jan. 13 by Landlord Investor who is our resident preferred stock expert on Yield Hunting.)
Since the election on 1/5/2021, rates have jumped to the upside, pressuring preferred stocks (down 2%), along with investment-grade bonds (down 1.5%) and Treasuries (down 3.9%).
The majority of the preferred stock market consists of low-coupon, investment-grade issues that are highly sensitive to interest rates. IG preferreds have been issued below 5% for months with the top of the market arguably being marked by a split-IG issue from insurer EQH with a 4.3% coupon.
Duration is a measure of interest rate sensitivity and it tells you how much the price of an issue will go down for each bip as rates move higher (all else being equal). For preferred stocks, the duration formula is 1/Rate. For example, a 5% coupon preferred at par has a duration of 1/0.05 = 20. This means that a 10 bps move higher in rates should result in a 200 bps decrease in price of the preferred. That would move the price to $24.50 at which point the preferred yields 5.10%. The lower the coupon, the greater your sensitivity to rates.
Year-end Wall Street estimates for the 10-year Treasury range from 1.3-1.5%. With rates moving higher on the back of stronger economic growth and higher inflation expectations, one should shift their preferred stock strategy to focus on the following categories.
Note: RILYM and OTCPK:SESCF go ex-div on 1/14.
Limited Duration Baby Bonds and Term Preferreds
The most straightforward way to limit your rate risk is to buy limited duration bonds or preferreds with mandatory redemption features.
PRIF-E: CLO CEF term preferred due 12/2024. 6.375% coupon, 8.2% YTM at a price of 23.50.
PRIF is a privately-traded CEF (purchased mainly via Registered Investment Advisors) managed by Prospect Capital ($5.9B AUM). They have six publicly-traded preferred stocks. The fund started in 2013 and has $530M in investment assets. Their historical performance is in line or better than the publicly traded CLO funds OXLC and ECC. As with those funds, PRIF typically trades at a premium to NAV which allows them to continually issue more common stock. As a result of these issuances, asset coverage of the preferreds is back to pre-pandemic levels over 300%. PRIF discloses NAV on a monthly basis and provides annual and semi-annual reports.
An overview of CLO CEF preferreds and what makes them safe is in this article on ECCX. CLOs are comprised of floating rate bank loans which benefit from higher interest rates and lower default rates from the economic recovery. While CLO common stock is too risky for many investors, the preferreds provide a large margin of safety.
RILYM: 6.375% Sr. Notes Due 2/2025. Price 25.10. Ex-Div 1/14.
RILYÂ is an absurdly successful investment bank that has grown EBITDA and its stock price by multiples over the past five years.
n February 2020. Since that time, Treasury rates are down 40 bps and RILY's stock is up 77%. Based on the 6.7% yield of RILY's preferreds, RILY should be able to issue sr. notes at 5.25%. So, the 6.375% RILYM is a good value compared to what rate RILY could get today. While call protection expires next month, RILY has seven bonds with higher coupons that will likely get called first. So, a call isn't happening any time soon.
There are pros and cons to each of RILY's bonds as they fall on different parts of the risk/reward spectrum; but at this time, RILYM is the best buy given that it is the lowest priced and will likely remain outstanding the longest.
RCA: Commercial mREIT 7% 2023 Sr. Unsecured Notes. Price 24.75.
Ready Capital (NYSE:RC) is a real estate finance company that services, finances, acquires, and originates SBA loans, residential mortgage loans, and MBS collateralized by SBA loans. They're also a PPP loan originator for which they earn substantial fees. RC essentially operates like a bank, but for small business and real estate loans only. Its debt:equity ratio is about 4, which means they stand roughly in between BDCs and merchant banks in leverage.
Credit metrics in their investment portfolio have bottomed and are showing signs of significant improvement. The next round of PPP loans should boost earnings again through origination fees.
The stock has rebounded strongly from the pandemic lows. Book value is $14.84, which is close to where the stock traded pre-pandemic.
the pandemic crisis, but since that time they've raised it twice and it is close to its prior level. They are in the process of acquiring residential mREIT Anworth (ANH) in an all-stock deal at a price that is below book value. The transaction is neutral to slightly positive from a credit perspective.
SCCC - Residential mREIT 7.75% 2025 Sr. Notes. Price $25.
Sachem (NYSEMKT:SACH) is a small real estate finance company that makes short-term, high interest rate "hard money" loans for the purpose of acquiring and renovating properties (mainly residential but some commercial). Their business has been buoyed by the strong housing market which is reflected in their stock price.
. With high quality hard assets backing their mortgages and their first lien position, even when there is a default, SACH expects to make a full recovery.
While technically an mREIT, they operate with a much lower BDC-level of leverage. Like BDCs, SACH's bonds have a covenant requiring 150% asset coverage for the bonds. However, unlike BDC bonds, covenant enforcement mechanisms are not strong.
High Coupon Cyclical Preferreds
A rising rate environment driven by an economic recovery favors cyclical industries such as financials and industrials. While most bank preferreds have low coupons with high duration and limited margin for spread compression, mREITs are a part of the financial industry with high coupon preferreds.
CMO-E: 7.5% Preferred priced at $24.40.
CMOÂ is a pure agency mREIT that primarily invests in adjustable rate mortgages (ARMs) which are well positioned for a rising rate environment. The steepening yield curve also benefits them by increasing their interest margins (the difference between their short-term borrowing rate and their long-term lending rate). Their portfolio carries no credit risk as their mortgages are implicitly backed by the federal government. No pure agency mREIT has ever missed a preferred stock dividend. Common stock covers the preferreds by 2.5x and core earnings cover the preferred div by about 4x.
CIM-A: 8% Preferred priced at $24.20
NYMTO: 7.875% Preferred priced at $23.
CIM and NYMTO are non-agency mREITs that earn money for taking the risk that borrowers will default on their mortgage. This risk can be decomposed into the risk that a borrower loses their job (source of income) and the risk that in foreclosure, the collateral is worth less than what is due on the mortgage plus administrative costs. While the risk of job loss remains high in the economy, government safety nets mitigate borrower loss of income. The economic recovery should turn the employment situation around post vaccine. More importantly, rising home prices decrease the likelihood of a loss from foreclosure.
Common stock covers the preferreds by 3x for CIM and 3.4x for NYMT. Core earnings cover the preferred dividend by 5x for CIM and 5x for NYMT.
ATCO-D: Atlas 7.95% Preferred priced at $25.20. Ex-Div 1/28.
SESCF: Atlas 7.125% 2027 Sr. Note. Priced at $25. Ex-Div 1/14.
GSLD: Global Ship Lease 8% 2024 Sr. Note. Priced at $25.34.
These three container shipping issues were covered in the last preferreds update here. Since that time, the booming container shipping market has boomed further. Shipping rates are at 10-year highs.
In the short run, shipping rates are being driven higher by a massive backlog at ports that are keeping ships stranded at sea, unable to unload their cargo. The backlog started with sailing cancellations caused by the March lockdowns. The industry has found it impossible to catch up on its backlog as COVID safety protocols have essentially reduced port capacity. Adding fuel to this fire is the surge in trade as people stock up on goods and spending on goods has replaced spending on services.
In the medium term, shipping is correlated with the industrial sector and emerging markets, both of which have a tailwind from the economic cycle. Higher oil prices also play a role in demand for ships as high bunker fuel prices cause ships to travel slower to save fuel. Slower travel effectively reduces the supply of ships.
Longer term, container shipping may be at the start of a super cycle. Shipping is notoriously cyclical since it takes years for a ship to be built, during which time the demand for shipping may change. After years of low shipping rates, ship orders are well below average which may fuel the next super cycle.
Pinned to Par Issues
Another way to protect yourself from higher rates is with issues that are "pinned to par." These are preferreds that would trade at a higher price were it not for the risk of an eventual call. As rates move higher, the incentive to refi the preferred decreases and a refi may no longer provide a reasonable return after accounting for transaction costs.
BSA: 5.125% 2031 Sr. Notes priced at 25.01. BBB-/Baa2
BSIGÂ is an asset management company with a high flying common stock price.
ar $1,000 institutional bond at under 2.5%. However, BSA has been callable since 8/2019 and it doesn't seem like the company is in any rush to redeem it. The 2031 maturity date limits duration significantly versus a perpetual preferred.
UMH-C: 6.75% Preferred priced at $25.10
UMH is a manufactured housing REIT that finances itself with non-recourse mortgages as opposed to bonds or loans. An overview of the company and the advantage of mortgage financing (from the perspective of preferreds) is in this article.
UMH has great access to capital as demonstrated by a mortgage they issued in August at a rate of 2.6%. Proceeds were used to redeem their 8% coupon preferred. On the earnings call, management hinted at using a similar transaction to redeem UMH-C when callable in July 2022. UMH-C was trading at $26.50 pre-pandemic. While UMH's housing assets have grown significantly in value since that time, UMH-C has not regained its pre-pandemic pricing due to the risk of an eventual call.
DX-B: 7.625% Preferred priced at $25.
DXÂ is arguably the best managed mREIT. Management was perfectly positioned for the pandemic crisis and the company had the smallest losses among their peers. As a pure agency mREIT, their investment portfolio is not exposed to credit risk. Just prior to the pandemic, DX did a partial call of DX-B. As markets heal, they will likely call the remainder of DX-B unless rates move higher.
Canadian Fixed Resets
Over on the Toronto Stock Exchange, a majority of preferreds are fixed resets. The coupon on these preferreds reset every five years based on five-year Treasury rates. A quirk of the Canadian market is preferreds more-or-less immediately price in the impact of higher or lower rates even if there's significant time until the coupon resets. As a result, the prices of these preferreds are very sensitive to movements in rates. This makes them an ideal investment in a higher rate environment.
There are a lot of complexities for US investors wishing to buy Canadian fixed resets. One of the simpler options are some of the Enbridge preferreds because they are denominated in USD and the coupon resets off of US Treasury rates. They're also listed in the US OTC market, so you don't need access to the Toronto Exchange.
OTCPK:EBGEF: 5.375% Preferred priced at $17.58. Current yield 7.7%. Coupon resets to the 5 Year Treasury + 282 bps on 3/1/2024. BBB-
A deep dive on EBGEF is here and a follow-up article on EBGEF is here.