This article was first published for Systematic Income subscribers and free trials on November 7th.
Welcome to another installment of our Weekly Preferred Market Review, where we break down preferred stock and baby bond market activity from the bottom up, highlighting news and events, as well as top-down, providing an overview of the market in general. We also try to add some historical context, as well as relevant topics that seem to be driving the markets or that investors should be aware of. This update covers the period up to the first week of November.
Be sure to check out our other weekly updates covering business development company (“BDC”) as well as closed-end fund (“CEF”) markets for insights into the broader earnings space.
The favorites fell once again in the week, and so far November is shaping up to be the fourth consecutive month down. Higher Treasury yields and lower equities were the key headwinds.
Retail preference yields continue to rise and remain at a 5-year high outside of a few days during the COVID crash. In our opinion, the sector remains an attractive location for new assignments.
Over the past year, we have seen a significant increase in floating rate prime issuance linked to longer-term rates. Historically, retail preferences, ie swap/traded, were issued as a fixed rate or linked to 3-month Libor after the initial 5-year fixed-rate period.
The ongoing transition away from Libor has pushed issuers to choose between keeping a short-term variable rate like SOFR or adopting a longer-term rate like the 5-year Treasury yield (i.e., 5-year CMT) as anchor for the variable rate after the initial fixed rate period.
Recent issuance has focused primarily on the 5-year CMT, with SOFR being less common. This makes sense as most institutional preferences are also pegged to 5-year rates, although most are also pegged to 5-year par interest rate swap rates in addition to the 5-year CMT rate. . It may seem surprising, but par interest swap rates are a more common reference point for “interest rates” in institutional space than Treasury rates.
That said, 3M Libor legacy preferences still dominate the industry. In our database that feeds our investor preferences tool on the service, we have 134 variable rate preferences linked to shorter-term rates, such as SOFR and 3-month Libor, and we have 26 linked to longer-term rates. , as 5-year Treasury yields, that is, 5 years. CMT. So how should investors think about allocating to one or the other?
In our opinion, it is important to consider the following factors. First, there is the simple matter of diversification. Most investors are likely to be primarily allocated to Libor-linked stocks, so having some allocation to CMT-linked stocks provides another source of portfolio diversification.
Second, it is important to consider the shape of the yield curve. Today, the yield curve is quite flat, which is quite unusual, as the chart below shows. The historical average spread between 5-year Treasuries and 3-month Treasuries is just over 1%.
What this means is that recent 5-year CMT issuance has been done at very favorable rates relative to historical levels. In other words, if the yield curve returns to its historical level, the 5-year CMT-linked shares will gain an additional 1% relative to the Libor/SOFR-linked shares. Therefore, the current flat yield curve provides an asymmetric risk profile that favors CMT-linked stocks.
Finally, another reason to watch CMT-linked stocks more closely is that the Federal Reserve has much less control over the longer end of the yield curve. In other words, if the Fed decides to suppress short-term rates, its ability to suppress long-term rates will be limited in the absence of new and unusual measures, such as yield curve control.
The risk for CMT-linked stocks is that the Fed decides to keep the policy rate high during a prolonged recession. In this scenario, which is already partially reflected in the yield curve, short-term rates may continue to be well above long-term rates, which will benefit Libor/SOFR-linked stocks. In our opinion, this is possible, but unlikely to be sustainable. In other words, a multi-year recession with the Fed keeping the policy rate high at all times is unlikely.
The 5-year CMT-pegged preferences worth looking at are as follows:
- American Equity Invest Life Holding Co. 6.625% Series B (AEL.PB)
- AGNC Investment Corp. Dep Shares Ser G Reset Rate Preferred (AGNCL)
- Rithm Capital Corp. Preferred Cumulative Series D Reset Rate (RITM.PD)
- SiriusPoint Ltd 8% Series B Resettable Fixed Rate (SPNT.PB)
Key details of these actions are shown below. The reduced yield is what these stocks are yielding today and the reset yield is what these stocks are expected to yield in their change to a variable rate.
This is how returns on these stocks are expected to evolve over time.
BDC Saratoga’s new 5-year bond (SAJ) started trading with a yield of 8.2%, which looks quite attractive. The company’s debt asset coverage was a solid 184% at the end of the quarter and this would have decreased marginally with this new issue. The company’s NAV has risen over time, which is good to see as it shows its underwriting is strong, which should protect debt. The bonds are not rated by a major agency, but would probably be around a BB level on a conservative basis. They are trading about 0.9% above the typical yield for BB corporate bonds.
In case you missed it, NLY.PF became (NLY.PG) in all taxable income portfolios. G has a lower yield until April 2023, but then increases to a yield that is about 0.7% higher than F over the long term (ie LT Reset Yield). The two series trade at the highest price spread, with F having risen at a high premium over G as it recently floated and jumped to a higher yield. However, once G floats, F will perform significantly less.