Guest Post: Preferred Stock Quick Picks - April 1 2019

This is a guest post by Landlord Investor.

Disclosure: Landlord Investor owns AGNCM, EBGEF, NCZ-A, and CORR-A

This is the second in a series of preferred stock articles. I suggest reviewing the first article which lays out the framework I use to evaluate preferred stocks and introduces a portfolio of preferred stocks that I like and still own. Today's article focuses on a few preferred stocks worth buying today. I plan to provide a more general overview of the state of the preferred market in a subsequent article.

AGNCM: AGNC Investment Corp., 6.875% Preferred Series D Fix/Float

Buy: Under Par

Description -- Fixed 6.875% coupon until 4/15/2024 when it floats to Three Month Libor plus 4.33%. It is also callable at that time. Not eligible for the 15% qualified tax rate but eligible for the 20% 199A tax deduction.

AGNCM is a recent IPO from the agency residential mortgage REIT AGNC. From a credit risk standpoint, AGNC is the safest of all mortgage REITs. It is one of the few mREITs that is still a pure play on AAA rated agency MBS. The common stock has a market cap of about $10B and they own about $80B of agency MBS. While not quite too big to fail, the failure of a company of this size would send shockwaves through the mortgage security market and probably the broader financial system. Interest rate risk is not a big factor since it goes to a floating rate in five years. 

The reason I consider the credit risk of an agency mREIT to be low despite the high leverage is that the underlying bonds have essentially no chance of default. That's not to say there is no risk in the company. In fact, for common stockholders there is a lot of risk because small changes in things like the shape of the yield curve and interest rates (whether up or down) can cause sharp declines in common stock book value due to the leverage. However, the fundamental creditworthiness of the underlying assets limits the size of the losses. Let's look at a few scenarios to understand why this is a safe company. These scenarios are greatly simplified since they do not take into account AGNC's hedging but they still give you a rough idea of the factors at play.

Scenario 1: Economy goes into a recession. In this scenario, interest rates go down which is supportive of the AAA-rated bonds held by AGNC. That said, prepayments (caused by people refinancing their mortgages) go up and this may reduce AGNC's income and even its book value. However, that's only a problem for the common stockholders. The amount of book value loss is capped by the premium over par of the bonds. As mortgages are refinanced, it puts cash back in AGNC's pocket that they can use to paydown debt if their Debt/Equity ratio starts getting into the danger zone.

Scenario 2: The economy booms and/or inflation goes higher and rates go up. In this scenario, higher rates lead to lower values for AGNC's assets. Book value likely drops. However, the yield curve likely steepens in this scenario which increases AGNC's income. So, while asset coverage for the preferreds decreases in this scenario, income coverage for the preferreds improves. There's really no reason why this scenario should jeopardize the preferreds, although it's not good for common stockholders.

Scenario 3: Panic grips the market and volatility shoots higher. In this scenario, the spread between agency MBS and treasuries increases due to higher volatility and stress in the financial system. The increase in spread drives book value lower but historically, spreads have always come back to their typical range once market volatility subsides. A backstop in this scenario (and any scenario) are AGNC's bond covenants. These require AGNC to maintain a certain level of asset coverage for their bonds. Should asset values drop and AGNC is in danger of breaching their covenants, they will be forced to sell assets until they have adequate coverage again. These covenants also protect preferred holders because the asset coverage requirements are high enough that assets will always cover both the bonds and the preferreds.

I particularly like the protection AGNC's preferreds have from a recession. This was demonstrated in the Q4 meltdown when AGNC's preferreds did not go below par. 

AGNC has two other preferred stocks. AGNCB is above par and will likely get called when callable in two months. AGNCN is also above par and has a yield-to-call of only 6.3%. While AGNCN has a 80 bps higher spread than AGNCM when it goes floating, AGNCN is still inferior to AGNCM which has a significantly higher yield-to-worst of 6.9%.

EBGEF: Enbridge Series 5 Preferred Shares

Buy: Under $20 (current yield of 6.7% or better)

Description: Starting March 1 2019, the coupon reset to 5.3753%. It is fixed at that level until March 1 2024 when it will reset to the five year US treasury rate plus 2.5553%. This preferred is denominated in USD and pays dividends in USD. Dividends are eligible for the 15% qualified dividend rate, however, dividends are also subject to 15% withholding by Canada. You can recover that withholding by applying for a foreign tax credit unless you hold this security in a non-taxable account. Therefore, this security is not suitable for non-taxable accounts.

Important Update Regarding EBGEFSomeone just informed me that it's safe to hold this security in a retirement account. Canadian tax withholding does not apply if the security is held in a non-taxable retirement account. Always best to verify these things from a second source but the below source seems pretty legit:"First of all, the 15% withholding tax that is normally imposed by the Canada Revenue Agency is waived when Canadian securities are held within U.S. retirement accounts."Canadian Taxes for US Investors: The Comprehensive Guide - Sure Dividend

This is an unusual USD-denominated preferred stock from the Canadian energy pipeline giant Enbridge. The preferred stock is listed on the Toronto stock exchange under the symbol ENB.PF.V. It is also listed in the OTC market in the US under the symbol EBGEF. EBGEF is a tracking stock and you will get the same price whether you buy it using the OTC symbol or buy it directly on the Toronto exchange. Enbridge has an unsecured senior bond rating of BBB+ and this preferred stock is rated BBB-. That's an excellent yield for an investment grade, qualified preferred.

Enbridge was founded in 1949 and is a diversified $73B USD market cap company that focuses on energy midstream assets in North America. They will become a dividend artistocrat this year which means they will have raised the dividend every year for the past 25 years. While they are in the same midstream energy space as many poorly managed and overleveraged disasters, they have a long history of conservative and prudent management. Enbridge has provided common stockholders a 17% CAGR total return since IPO in 1996 which crushes the total return of the S&P 500 and the S&P 500 Energy Sector. Management has guided for a 10% increase in the common dividend in 2020. 

Despite the strength of the parent company, the preferred stock has been surprisingly volatile. From 2015 to 2016 it crashed from $25 to $15. During the Q4 2018 meltdown it went from $22 to $18. The only explanation I have for this volatility is that the preferred was overpriced at IPO which led it to quickly trade below par. Preferreds that trade below par tend to be more volatile. However, this only explains a small amount of the volatility.

Another risk factor for this preferred is low liquidity. Bid-Ask spreads tend to be around 10 cents and there are not a lot of shares traded daily. It's also hard to get quotes and statistics on the preferred since many brokers (such as E-trade) don't provide quotes on Canada listed stocks. I get delayed bid-ask quotes from Interactive Brokers and rudimentary charts from Google. 

For reference, here is the press release showing the preferred's new dividend rate:

NCZ-A: AllianzGI Convertible & Income Fund II, 5.50% Series A Preferred Shares

Buy: Under $24.25. Alternatively, you can buy NCV-A when its price is less than 40 cents higher than NCZ-A.

Description: Call date of 9/11/2023. Based on historical data, you can expect about 20% of the dividend to qualify for the 15% tax rate. The remainder will be ordinary dividends.

This preferred was covered briefly in the last preferred stock review but I like it more today even though it has gone up in price. The reason is that the 10 year yield has declined. NCZ-A is rated AAA by Fitch and I estimate fair value at a 250 bps spread to the 10 year. With the 10 year at 2.5%, I think NCZ-A should trade at a yield-to-worst of 5% which would put the price well over par.

Why is NCZ-A rated AAA? It is the preferred stock of a CEF managed by Allianz that invests in high yield and unrated convertible bonds, standard bonds and preferred stocks. As a CEF, its preferreds are subject to the 1940 Act which requires the company to maintain 200% asset coverage for the preferreds. If they fail this asset coverage test, they cannot declare a dividend for CEF common stockholders. If the fund fails the asset coverage test at the end of the quarter, then they must sell assets and buyback preferred shares at par until they get back in compliance. 

One of the keys to NCZ-A's safety is the liquidity of their assets. While there are other CEF preferreds out there, some of them are invested in less liquid CLOs or senior loans. In the event of an unprecedented financial crisis that requires the fund to liquidate, having more liquid assets ensures that NCZ is able to obtain prices for its assets that are close to the last mark. Another factor increasing NCZ-A's safety is the size and positive reputation of the fund's sponsor. Allianz is one of the world's largest asset managers which reduces the chance of fraud, rogue management, or accounting issues causing an unexpected and dramatic fall in asset values.

CORR-A: CorEnergy Infrastructure Trust, 7.375% Preferred Shares

Buy: Below par after accounting for accrued dividends. About 15 cents of dividends have accrued as of April 1, so it is a buy at $25.15 or below.

Description: Call date of 1/27/2020. Dividends are not qualified but are eligible for the 199A deduction. 

CorEnergy (CORR) is a small $470M market cap energy infrastructure company that is organized as a REIT. They are a unique energy company due to their conservative management and niche assets. They are non-diversified as the company only owns four assets and one of those assets accounts for about 40% of EBITDA. 

What I like most about CORR is their conservative leverage. While a conservative BBB+ rated midstream company such as EPD may sport a 3.5x net debt/EBITDA ratio, CORR-A's ratio is less than 1x. That's right, their 2018 EBITDA exceeds their net debt. That will likely change as the company is planning to purchase more assets but low leverage has always been part of their core operating model. Management has also exercised great caution and prudence (common stockholders may complain the caution has been excessive) in waiting for the right opportunity before purchasing assets. 

CORR's asset quality is another great factor. They own mission critical infrastructure for the production of oil/gas with low marginal costs. A good example is their Gulf of Mexico gathering system which is their largest asset. Offshore wells are expensive to drill but once drilled, they produce oil with little marginal cost. They also have slow decline rates, so the wells produce oil for a long time. As a result, even if the price of oil drops and new drilling stops, the existing wells will still require the use of CORR's infrastructure for many years. 

Other examples of mission critical infrastructure include their natural gas pipeline that is the only source of supply for many of their St. Louis area customers. They also provide the sole source of natural gas to the Defense Department's Fort Leonard Wood under a 10 year contract that's in its initial years.

While CORR's asset quality is high, their tenant quality has not always been high. In 2016, they had two of their tenants declare bankruptcy. However, since the marginal cost of producing energy was low for these customers, and they could not operate without CORR's infrastructure, they continued using the infrastructure and paying rent throughout their reorganization and after their emergence from bankruptcy. These two cases were a great test of the resiliency of CORR's model.

CORR bought back on the open market about 3.5% of their preferred stock during Q4 2018 and January 2019 at 95% face value. There is a good chance that they will continue to buyback preferred shares if they dip below par which will keep the price supported. It's also likely that they will call the shares when callable in 2020.