CA - Brookfield Infrastructure: 7.8% Yielding Preferreds Appear Undervalued

2024-01-08 18:00:00 ET

Summary

• Preferred shares and bonds have had a substantial rally off the October lows.
• Now is generally not a good time to add duration or credit risk.
• We tell you why we bought some BIP.PR.B at $15.65 anyway.

In the last few weeks, we have witnessed one of the broadest and also the strongest rallies. Equities of all shapes and sizes have gone up and bonds and fixed income products have not been far behind. On the fixed income side, while we bought the panic, we also have started trimming on the way up. Simply expressed, we have zero FOMO and only aim to be invested at the right prices. Of course, such wide rallies create a problematic stance when you need to be at least partially invested. This is even more true with our expected return profile from common equities bordering on 2% annually from here . So we need some preferred shares to navigate this, but which ones? We go over one set of attractive preferred issues that have not joined the party yet and tell you why we just added a little last week.

Brookfield Infrastructure Partners ( BIP ),( BIP.UN:CA ) and its corporate counterpart, Brookfield Infrastructure Corp. ( BIPC ), need little introduction. Even the ones that were not aware of it were given an introduction by some "interesting" short side theories. As it turned out, those were released literally to the day the stock actually bottomed. Go figure. But we are not here to debate the common units/shares. We are going to focus the discussion on the preferred shares. In the US, there are two preferred shares listed. Brookfield Infrastructure Partners L.P. 5.125 CL A PFD13 ( BIP.PR.A ) and Brookfield Infrastructure Partners L.P. 5.00% PFD A 14 ( BIP.PR.B ). With the preferred shares, you are not even betting on the fair valuation of the company. You are not playing on the income statement, just making a gambit on the balance sheet. On that balance sheet, you get a diversified set of assets with long term earnings potential.

To make the long term bull case on the common units, you have to buy into a lot of what is said on the next slide.

But for the preferred units, the key points are the BBB+ investment grade rating and the debt structure shown below.

Comparatives

The key reason to bring you this today is that while other preferred shares have run-up, BIP.PR.A and BIP.PR.B remain undervalued. A good way to examine this is to compare their current yields with other securities with the same structure and same credit rating. While BIP itself is rated as BBB+, the preferred shares are rated as BBB-, two notches lower. Pulling up the preferred stock comparatives with those ratings, we can see that the median BBB- preferred share yields around 6.2%.

The list above also has many preferred shares trading over par which have lower yield to call. Those create a different sort of risk dynamic for investors. For example, Lincoln National Corporation 9% DEP PFD SR D ( LNC.PR.D ) are callable on December 1, 2027. The last dividend was paid in November 14, 2023. Ignoring the stripped yield and just pricing in 4 years more of dividends (till December 2027), gives us a yield to call of again, under 6.2%.

So it would be dangerous that all of these are comparable. We next look at yields by dropping out all the ones trading over par.

Whether you go by the first list or the second, BIP.PR.A and BIP.PR.B are clear standouts, getting right to the top of the list. In fact, when we issued our alert, BIP.PR.B was at $15.65, and yielded higher than anything else on the list.

What Is Fair Value?

Do note that the two have slightly different coupons (BIP.PR.A at 5.125% and BIP.PR.B at 5.000%), so it makes sense for BIP.PR.A to trade at a higher price. But if we assume both yield 6.2%, we can easily extrapolate a $20 plus price for both. That makes no assumptions about further improvements in the risk-free rates or a return to ZIRP (zero-interest rate policy). So the two preferreds have substantial upside alongside a nice yield. But that does make an assumption that the rest of the preferreds are fairly priced.

To reach our own version of current fair value, we like another comparative, the yield on these preferreds relative to longer term investment grade bonds. For this the yield and price of iShares 10+ Year Investment Grade Corporate Bond ETF ( IGLB ) works pretty well. This ETF holds bonds with 20 plus years of average maturity and matches the duration risk of investment grade preferreds pretty well. The average credit quality is slightly higher for IGLB and it tends to yield less than BBB- preferred shares.

In general, we consider a 1% spread over IGLB for BBB- preferred shares to equate to fair value. Some might insist on a wider spread as IGLB has a fixed maturity of bonds. Others might insist on a smaller spread as most preferred shares have at least a partial tax advantage over the interest received from bonds. That is probably why some preferred shares like Federal Realty Investment Trust 5% CUM PFD C ( FRT.PR.C ), have almost zero spread versus IGLB.

We are sympathetic to both arguments, but feel 1% is a fair spread that balances the perpetual nature of preferreds alongside the tax advantages. Based on that logic, almost all BBB- preferreds today are overvalued. You can see that Rexford Industrial Realty, Inc. 5.625 CUM PFD C's ( REXR.PR.C ) yield of 6.46%, is what we would put right at fair value (IGLB yield + 1%). BIP preferreds and Brookfield Renewable Partners L.P. 5.25% PFD CL A ( BEP.PR.A ) are the only one that look substantially undervalued today.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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