HT - Give Yourself A Raise: Yield Arbitrage In The Hersha Hospitality Capital Stack

2023-06-29 16:15:21 ET

Summary

• The article discusses an arbitrage opportunity between Hersha Hospitality Trust 6.875% Series C Preferred and Hersha Hospitality Trust 6.50% Series E Preferred.
• I highlight the challenges of arbitrage trading within small-cap issues, including illiquidity and low trading volumes.
• Despite these challenges, I argue that attentive, active investors can achieve superior results through disciplined investment strategies.
• I also provide considerations for small-cap preferred arbitrage, including understanding the issuer and the issue's market, being disciplined in pricing or volume, and identifying any potential frictions that might affect the trade's return.

Back in February of 2012, I published my first Seeking Alpha article with the alliterative title, Pricing Anomalies In Pari Passu Preferreds Present Fleeting Opportunities . The gist of the report was that nearly identical preferreds, from the same issuer, were trading at disparate prices, yields, and discounts to liquidation preference; a savvy trader could improve her returns by selling the dearly priced issue and buying the cheaper one. As it happens, the same type of arbitrage is available in the Hersha Hospitality ( HT ) preferred equity stack today. Specifically, we are looking at the arbitrage between Hersha Hospitality Trust 6.875% Series C Preferred (HT.PC) and Hersha Hospitality Trust 6.50% Series E Preferred (HT.PE).

At Portfolio Income Solutions, we maintain a real time Arbitrage Tracker to spot pricing anomalies in companies involved in recently announced M&A activity. Serving the same purpose, and possibly more evergreen, are our mREIT and equity REIT preferred data tables. When pricing inverts or gets out of whack, we are alerted to the potential of a possible trade. On June 28 ^th , the Hersha Hospitality equity capital stack looked like this:

The Trade

The table shows that HT.PC last traded at $19.72 which provides the purchaser a dividend yield of 8.71% at cost. Concurrently, HT.PE last traded at $20.00 which provides the purchaser a dividend yield of 8.125% at cost.

Both issues are preferred shares with the same liquidation preference from the same issuer. The better opportunity is to purchase the higher yield at a bigger discount to par. If you own HT.PE, you can sell it at $20.00 and plow the proceeds into purchase of the higher coupon HT.PC at $19.72 and improve your dividend yield by 60 basis points.

Simplistically Stated - The Long View Advantage

As an example, the holder of 1,000 shares of HT.PE receives $1.625/share in dividends annually or $1,625. If she sells the HT.PE and buys 1,000 shares of the higher coupon HT.PC, she will receive $1.71875/share in dividends annually or $1,719 for a 5.78% increase in dividend income. But wait, there’s more.

The $20,000 proceeds from the HT.PE sale will actually buy 1,014 shares of HT.PC at $19.72/share in today’s market. The enhanced share count takes the dividend income to $1,743 annually, a 7.25% increase in dividend income. Attentive, active investors can put dividend growth investing on a higher plane.

If you hold that advantage over an extended period, the spread compounds on reinvestment, and so does your money. The enhanced dividend income spends and reinvests better in these inflationary times and if the shares are ever called, you net higher proceeds.

The Laborious Nuances of Small Cap Arbitrage Trading

If yield arbitrage was easy, everyone would be doing it. We have to acknowledge the subtleties and nuances of arbitrage trading within small cap issues.

I liken efforts to optimize investment results to the efforts we extend to remain fit, strong and healthy. The effort is constant and sustaining. Discipline in investing produces a sustained, superior result.

At the top of the article, I described that I had, more than a decade ago, identified an arbitrage opportunity within Hersha Hospitality’s equity capital stack. While this opportunity has resurfaced, it has its limits.

At $240MM, HT is a microcap equity. Beyond the common, HT.PC ($75MM), HT.PD ($192.5MM), and HT.PE ($100MM) are thinly traded and suffer from a sustaining illiquidity endemic to all small cap issues. Each preferred issue averages a trading volume of less than 10,000 shares per market day.

As a firm, we currently hold more than 50,000 shares each of HT.PD and HT.PE; these holdings represent more than 5 days trading volume if we chose to be the whole market. We would like to instantly convert our HT.PE position into the better priced, higher yielding HT.PC shares; instead, we have to deal with what we can capture in the market. Last week, we liquidated about 2,400 shares of HT.PE at an average price of $20.07 and reinvested proceeds into shares of HT.PC at an average price of $19.51. We incrementally improved our yield and also improved our potential gain to call. This is a never-ending, portfolio management process that we will always be dealing with. Forever in the pursuit of six-pack abs.

Repositioning illiquid assets to gain a small pricing advantage is not compelling to institutional investors. It might, however, pique the interest of active Seeking Alpha investors.

Considerations for Small Cap Preferred Arbitrage

1. Underwrite the Issuer

In the case of Hersha, we know the management, have toured properties, and conducted continuous due diligence for more than a dozen years.

1. Understand the issue’s market

The price may look cheap in current conditions, but circumstances may make you hold the position for longer than you intended. Buy it only if you are comfortable in holding it forever.

1. Be disciplined in your pricing or volume

Markets only bear so much; don’t try to buy or sell too much. Never place a market order. Set your selling prices and buying prices to achieve the desired spread or advantage.

1. In measuring a trade’s potential return, identify any frictions that might diminish your result (like capital gains taxes or wash sale rules).

If you found this discourse interesting, you may have the characteristics essential to being an active investor. Passive investors will more fully enjoy their beach vacation. Active investors will keep nervously checking their phones and might enjoy higher returns.

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