This article was first published for Systematic Income subscribers and free trials on November 2nd.
An unusually fast pace of interest rate hikes by the Fed has rattled the preferred market, creating big jumps in preferred yields that switch to a variable rate coupon and generating significant alpha opportunities for well-informed investors. In this article, we discuss the Annaly (NYSE: NUMBER) preferred suite and highlight our recent rotation to the G Series (NYSE:NLY.PG) of the F-series (NYSE:NLY.PF) despite its lower stripped performance to date. We also highlight some myopic trends in the retail preferences market that continue to offer opportunities for investors.
The favorites soon to float are Kings Of The Hill
Investors who have been following the preferred market have probably noticed an interesting pattern in which the market can take some time to notice an upcoming yield change for a preferred approaching its first call date.
For a fixed/floating preference, the arrival of the first call date means your coupon will change to a variable rate. And because current interest rates are high relative to their 5-year history (non-redemption periods tend to be 5 years at the time of issuance), the variable-rate coupon will in almost all cases be well above the previous fixed coupon, which will result in a large jump in the stock’s return on the first redemption date, unless it is redeemed.
The chart below shows AGNC’s preferred suite, clearly highlighting that AGNCN, which switched to a variable rate coupon in mid-October, has remained much more resilient than its counterparts that have first call dates in 2024-2025 (we exclude the recently issued AGNCL as it was not listed at the beginning of the year but has also sold off strongly).
The set of preferred NLYs where NLY.PF has recently switched to a variable rate coupon shows the same pattern.
We started highlighting these two favorites back in April when the market wasn’t doing a good job of differentiating them from the rest of the pack. As the date of the first call approached, the market began to realize that AGNCN and NLY.PF would not only greatly increase their returns, but would also have the highest returns in their respective suites. The small probability of redemption also tended to anchor their prices closer to “par”.
The key takeaway here is that the market may take time to catch on to the variable rate change on the first call date. This is because most preferred investors don’t have the whole picture in front of them and don’t look to the future. Specifically, most investors assign preferreds based on the performance they see from their brokerage, which is retrospective. This yield is not relevant for preferreds that will switch to a variable rate coupon in the medium term. To measure this forward yield, investors not only need to know the first call date and floating rate coupon details, but also the forward rates on the first call date to make an informed yield calculation. This is frankly beyond the capacity of most income investors, and is why the retail preference market is rich in alpha and value opportunities. Next, we discuss how we adopt this pattern in the form of a rinse repeat in the NLY suite.
Why we prefer NLY
In addition to highlighting this interesting pattern in the retail market, this article also discusses our allocation to preferred NLYs within the broader agency mREIT subsector. We view the sector as attractive due to the unusually cheap level of agency MBS. In addition to NLY, it also contains mREITs such as Dynex Capital (DX), AGNC Investment Corp (AGNC), Armor Residential (ARR), and Invesco Mortgage Capital (IVR). All of these companies primarily focus on Agency MBS in their portfolios.
There are two reasons why we favor NLY preferences in the subsector. First, we like the convex behavior exhibited by NLY with respect to its preferences. This has to do with how it responds to large declines in book value. In the third quarter, the company issued 16% more common stock in response to falling book value. The net result is that while book value fell 15%, equity, which is what the preferreds really care about, fell just 1.2%. Since book value has been falling this year, the company increased its common stock by a whopping 29%.
AGNC and DX have also issued new common shares, but not in such large numbers. In other words, a large drop in book value causes NLY to issue common stock, which softens the impact on preferred stock. And if we see a big increase in book value, NLY is likely to do nothing (ie not buy back 29% of its recently issued shares), leaving the preferreds much better off thanks to an organic capital increase.
This convexity of little loss from equity coverage on the downside and a large potential gain from equity coverage on the upside is a good profile for preferreds. In this regard, preferred NLYs offer much greater convexity than their industry peers. There’s no guarantee that NLY will continue to be as bold with the downside issuance of common shares, but the fact is that it has been so far, leaving its preferreds far better off than others in the industry.
The other reason we like NLY in the subsector is that NLY tends to be a bit more conservative. For example, while DX and AGNC increased their leverage levels in Q3 (to 8.5x and 8.7x), NLY actually lowered it substantially from 6.6x to 5.8x.
A higher level of leverage is more attractive to common stock investors who are bull agencies. However, preferred holders are much more interested in downside risk than upside gains, so, all things being equal, they prefer lower leverage levels.
The net result of these two factors is that NLY not only has the highest equity/preferred coverage (shown in parentheses on the label below) and also the lowest leverage in the non-IVR sub-sector. Using the combination of both metrics, it is way ahead in the subsector.
Switch to G Series
In this section, we discuss our thinking behind the recent switch to NLY.PG from NLY.PF.
This is what NLY’s preferred suite looks like.
Since the beginning of the year, the price spread between NLY.PF and NLY.PG has continued to grow.
As highlighted above, this is because more and more investors have become aware of the upcoming sharp jump in NLY.PF’s yield, as well as a small probability of NLY.PF redemption. After the price spread reached close to 18%, we pulled the trigger and rotated NLY.PG into our income portfolios, as highlighted by the green circle.
Let’s look at the performance picture of the suite. What it shows is that after its switch to a variable rate coupon, the yield on NLY.PF (yellow line) jumped to around 10% and will climb towards 10.5% in the coming months as rates rise. short term continue to rise. on the back of continued Fed hikes. Stock yield will remain around 2-2.5% above NLY.PG for several months and above NLY.PI until mid-2024 .
However, keep in mind that when NLY.PG’s first call date arrives on March 31, 2023, it will outperform NLY.PF and remain above it in perpetuity. That is why we have chosen to rotate NLY.PG from NLY.PF. We are willing to sacrifice 2% in terms of performance over 5 months, but get a performance increase of around 0.7% (at the time of the switch) over a much longer period.
And as we highlighted earlier, we also expect the market to start to take notice of this dynamic in the coming months, as realized by NLY.PF’s switch to a floating rate coupon and its jump in yield to the highest level in the suite room. Eventually, if NLY.PI holds at an attractive price, it will make sense to switch to it on a rinse/repeat basis, taking advantage of the market’s delayed reaction to coupon changes.
Clearly these preferences can be redeemed, however this seems unlikely, particularly in the case of NLY.PG as it is trading at a reduced price of around $20.70. However, if it does happen, it will be a gift to investors, as NLY.PG also enjoys the highest return to call in the suite.
The key takeaway here is that a focus on term yields is an essential component of prime investing, particularly in an environment where short-term rates are moving rapidly and are expected to end very high. This, coupled with the fact that the retail preference market tends to be slow in this regard, continues to offer alpha and value opportunities for investors.