Yield Hunting: Alt Inc Opps
byAlpha Gen Capital
Preferred Stock Review: Some Buy Candidates Remain
Feb. 25, 2019 10:53 AM ET•CIM, NGHC, OAK•12 Comments
While preferred stocks have largely recovered their recent weakness, there are still opportunities in the space.
We present a portfolio of preferred stocks that are attractive at current prices or slightly lower prices.
The upcoming preferred stock index transition may provide opportunities for bargains.
Have a shopping list ready!
Guest Post: Landlord Investor
Disclosure: Landlord Investor owns all the preferreds listed in the table except for CORR-A.
Like many CEFs, preferred stocks were subject to vicious tax loss selling in Q4 that brought many issues well below intrinsic value. In times of volatility, preferred stocks can experience equity-like volatility even though their underlying value varies much less than equities. Since the bottom in December, preferred stocks have ripped higher but some values still exist in the space. It's still not a bad time to add diversity to your portfolio with preferred stocks (if you don't have them) or swap existing positions into new opportunities.
One potential catalyst that may create opportunities in preferreds is the ongoing transition in the preferred index fund PFF. That ETF is changing the index that it tracks over the next several months. As a result, PFF will be adding or subtracting preferred stocks which can create significant price dislocations. These dislocations could create some nice opportunities to pickup preferred stocks, so have your shopping list ready!
Below is a table of preferreds I like that are "buys" or "holds" at current levels. Buys are preferreds with potential for capital appreciation while Holds are good as part of a diverse portfolio of income securities but do not have significant capital appreciation potential. Table 1 provides key statistics that describe the preferreds that are Buys or Holds. Table 2 evaluates the preferreds on a set of factors. Following Table 2 is a description of each evaluative factor and examples of how they were applied to preferreds in the table. Note: I'm using the term "preferred stock" to refer both to traditional preferred equity and exchange traded debt (aka "baby bonds").
Table 1: Potential Preferred Stock Opportunities.
Table 2: Preferred Stock Evaluative Factors
Description and Application of Evaluative Factors
Discount to Sr. Bonds -- One of the best ways to uncover preferred stock opportunities is to identify preferreds that trade at a discount to what you would expect based on the senior bonds. As a rule of thumb, junior bonds have a credit rating one notch below sr. bonds and preferreds have a rating that is another notch lower. So, if a sr. bond is rated BBB, then the jr. bond should be rated BBB- and the preferred should be rated BB+. Based on these ratings, I generally estimate that a jr. bond should yield 75 bps more than a sr. bond and that preferreds should yield an additional 75 bps. For example, if the sr. bonds yield 6%, then the jr. bonds should yield 6.75% and the preferreds should yield 7.5%. This is a general rule and there are exceptions (distressed companies should have wider spreads between sr. bonds and preferreds) but I won't consider a preferred that doesn't yield at least 150 bps more than its sr. bonds.
Nustar Energy's NSS is an example of a jr. bond that trades at an excessively large spread to the sr. bonds. Nustar's 2027 5.625% Sr. Bond trades above par with a Yield-to-Maturity of 5.5%. However, NSS's yield is a full 375 bps higher. Part of the reason may be that Moody's rates both Nustar's jr. debt and preferred stock at B+, two notches below its sr. bond which is rated BB. I strongly disagree with giving the jr. debt the same rating as the preferreds, especially when there is a huge amount of preferreds behind the jr. debt in the capital stack. Another reason for NSS's high yield is the coupon is floating and rates have risen substantially, however, the price is stuck close to par since the issue is currently callable. Overall, NSS is significantly undervalued versus its sr. bonds and is a strong buy if you can get it below par (after accounting for accrued interest). While it is currently callable, I don't think they will call it in the near future. Also, the sr. bond appears to be priced correctly and it is the jr bond that is mispriced. Nustar's credit profile is consistent with its BB rating and the sr. bond's 5.5% yield is consistent with that BB rating. Note: I also like Nustar's preferreds (NS-A and NS-C) which also trade at an excessive discount to the sr. bonds.
Discount to Comparable Preferreds -- Another way to uncover undervalued preferred stocks is to benchmark them to other preferred stocks within an issuer's family of preferred stocks or to benchmark them to preferreds issued by peer companies.
RILYZ is an example of a security that trades at a discount to sister securities within their family. RILYZ trades below par with a yield of 7.55% while RILYH trades above par with a current yield of 7.22%. An even bigger discrepancy exists with RILYI which only yields 6.75%. RILYI is the most recently issued RILY bond and was market priced at issuance in September 2018, so it's likely the most accurate reflection of RILY's cost of debt capital. RILYH and RILYI mature in 2023 while RILYZ matures in 2027 but that doesn't justify such a large spread in yield. Given the strong performance of the underlying business and its credit metrics, I believe RILYI with its 6.75% yield is the one that is correctly priced.
TWO-E is a legacy CYS preferred that Two Harbors kept after it acquired CYS. For some reason, it has traded at a persistent discount to the other TWO preferreds despite having a larger discount to par.
PBC trades at a small discount to PSEC's other exchange traded debts (PBB and PBY) and a whopping 150 bps discount to its bond market traded debt. While PBC's maturity is a few years longer than the other debts, the spread between PBC's yield and the yield of the other securities cannot be justified by that difference in maturity.
Above Average Price Stability in Q4 -- One of the biggest factors in choosing a preferred is understanding how it will perform in a volatile market. The best way to do this is to look at actual historical volatility during volatile markets. The bout of volatility in Q4 is the most important time period to examine but it's also worth looking at how the preferred performed in 2015/2016 if it existed during that timeframe.
RLJ-A is a good example of a preferred that performed well in Q4. RLJ-A had a max drawdown in Q4 of 5% while PFF's max drawdown was 7%. However, max drawdown isn't the only factor I look at for price stability. Throughout the downturn in Q4, RLJ-A's price decrease consistently lagged the decrease in PFF. It's hard for any preferred stock that's part of the index to diverge from PFF since PFF owns such a large percent of all outstanding preferred stock (I think over 10%). However, if a preferred's price is lagging the downturn in PFF it means the preferred is merely getting dragged down by PFF rather than experiencing a more fundamental issue. Importantly, the lag effect gives you time to react by selling before the price catches up to the index.
Note, while CIM-D didn't exist during most of Q4, its sister securities performed very well. In fact, CIM-B (which has the same 8% coupon as CIM-D), never traded below par in Q4.
Common Stock Long Term Performance -- One of the best ways to value preferred stocks is to triangulate its value between the bonds and the common stock. Bonds and common stock are held by "smart money" institutions and are usually a more accurate reflection of the underlying company than the preferreds. We already talked about how to use bond prices to uncover preferreds at good values, now we'll cover using stock prices. There's no formulaic method for using stock prices to value preferreds. However, a negative trending common stock price is a red flag for a preferred that must be investigated. A positive trending common stock gives you a margin of safety because that trend will break down and reverse before the preferred stock will start going down. If you see the common stock breakdown, that's a good time to consider selling your preferred position.
National General (NGHC), B. Riley (RILY), and Chimera (CIM) are examples of issuers with strong long term common stock performance. The five year common stock performances for NGHC and RILY are 80% and 236% respectively. Chimera has a more modest gain of 21% but the total return is much higher since Chimera has an 11% dividend. Exantas (XAN) is undergoing a turnaround under new management, so I use the one year stock performance -- 20%.
Common Stock Stable Q4 2018 -- Just as I look at the preferred stock performance in the real life "stress test" during Q4, I also look at the common stock performance. A great example of a common stock that stood like a rock during the market swoon is Oaktree Capital (OAK). OAK experienced a max drawdown in Q4 of 2.7%. The preferred stock actually vastly underperformed the common in Q4 and when I saw that happen for an investment grade company with excellent management, it was a green light to back the truck up on the preferreds. Going forward, if there is another recession-scare, OAK will likely stand strong regardless of whether retail preferred holders drive down the preferreds to bargain levels. The reason OAK stock performed so well is due to its recession resistant features which I will cover later.
Preferred Stock to Common Stock Market Cap Ratio -- Common equity is the cushion ahead of preferred stock in the capital stack. So, a key measure of safety is the size of that cushion. The best way to measure common equity is the market capitalization of the common stock. I favor this measure over balance sheet equity as market cap is the market value of the equity rather than an accounting measure which may not accurately reflect reality.
RLJ-A is a great example of preferred stock with a huge common equity cushion ahead of it. The par value of RLJ-A is $323M while the common stock market cap is 3.4B. So, the preferred stock is covered 10.5x by the common stock. The reason for this high ratio is that RLJ-A was inherited by the company when it acquired Felcor Lodging. RLJ has not issued any preferreds and it doesn't seem likely they will issue any in the future. So, this high coverage ratio will likely persist.
Self-Hedging Business Features -- I favor preferreds from companies with income streams or assets that are inversely correlated to each other. That way, if one income stream or asset portfolio goes down, the other is likely to go up.
CIM-D and TWO-E's issuers are hybrid residential mREITs which have self-hedging features. Hybrid mREITs own both rate risk assets (agency MBS) and credit risk assets (non-agency RMBS and CMBS). Generally, rate risk assets do best when rates are going lower such as in a deflationary/recessionary environment while credit risk assets do best in the opposite environment. Hybrid mREITs do a lot of hedging that skew these relationships but generally speaking, credit and rate risk assets are inversely correlated.
RILYZ's issuer is another example of a business with self-hedging features. B. Riley is a broker-dealer with a bankruptcy/liquidation business. While this business line is small today and represents less than 10% of their revenue, in a recession it will likely grow and offset declines in their cyclical business lines.
Recession Resistant Business
Oaktree Capital is a great example of a recession resistant business. While most asset management companies will likely lose assets in a recession, and thus income from asset management fees, Oaktree is well positioned to maintain or even grow its assets under management in a recession. Oaktree has hundreds of millions of dollars of "dry powder" in the form of capital commitments. These commitments can be drawn upon during a recession to bolster assets under managements and related fees/income. Oaktree's investment philosophy is to wait for an economic downturn and then draw on capital commitments to buy distressed assets at bargain prices.
While Teekay LNG is in the volatile shipping business, I consider their model to be recession resistant due to their long-term leases, strong counter-parties and the long term growth in demand for LNG shipping. TGP is exposed to several company-specific risks but their underlying business should not have a lot of sensitivity to the economic cycle.
Preferred stocks are generally stable but can be subject to vicious tax loss selling. For that reason, large, broad-based declines in preferred stocks are usually isolated to the end of the year and are most pronounced in preferreds that were issued that year. We saw sharp declines in preferred stocks at the end of 2011, 2013, 2016, and 2018. There was also a modest decline at the end of 2015. In each of those cases, much of the late year decline was recovered within the first couple of months of the new year.
While much of the decline in preferreds in Q4 has been recaptured, there are still some values in the preferred stock space. Furthermore, the transition of PFF to a new benchmark is creating new price dislocations that will lead to further opportunities.