NYMTM - Preferreds Weekly Review: Funds Vs. Individual Preferreds Debate

2024-01-03 05:49:21 ET

Summary

• We take a look at the action in preferreds and baby bonds through the second week of December and highlight some of the key themes we are watching.
• Preferreds rallied for another week, closing in on a 10% total return for the year.
• We touch on the debate of whether it makes sense to hold preferreds funds or allocate to individual preferreds.
• Mortgage REIT CHMI has authorized a repurchase of up to $50m of its preferreds, while NYMT has cut the dividend on its common shares due to a transition in its portfolio.

Welcome to another installment of our Preferreds Market Weekly Review, where we discuss preferred stock and baby bond market activity from both the bottom-up, highlighting individual news and events, as well as the top-down, providing an overview of the broader market. We also try to add some historical context as well as relevant themes that look to be driving markets or that investors ought to be mindful of. This update covers the period through the third week of December.

Be sure to check out our other weekly updates covering the business development company ("BDC") as well as the closed-end fund ("CEF") markets for perspectives across the broader income space.

Market Action

Preferreds extended their strong run for another week as the Santa Claus rally buoyed the income market at the end of the year.

Yields touched nearly 7%, well off their 8% high only a few months ago.

Preferreds credit spreads continued to inch lower, now trading close to their tights since 2022, though wider of their 2021 levels.

Year-to-date, preferreds delivered a total return of around 10% - very respectable for a fairly high-quality sector and despite the bank wobble during the year.

Market Themes

One question we often hear is why would investors select individual preferreds if they can just hold a diversified fund instead? Often the fund in question is either a cheap passive fund or an actively-managed one like a preferred CEF.

In one sense, this is simply a question of sector familiarity and necessity. Few investors who have spent some time digging into individual preferreds pose the same question - instead, they are quite happy allocating to individual preferreds. Investors who, on the other hand, are not familiar in the market have to make do with a fund.

One obvious reason to allocate to individual preferreds is because doing so allows investors to tailor the risk/reward of their sector exposure. Investors who want to tilt to higher-quality preferreds such as Utility shares, for example, can do so. Furthermore, investors who want to express a view on the path of interest rates, can do so as well, by allocating more or less to floating-rate, fix/float vs. fixed-rate shares.

Funds cannot do this as easily as they are either passive or because they still have to hold fairly diversified portfolios of many securities even if being actively-managed.

Another reason many investors hold individual preferreds is that the retail exchange-traded preferreds market is not particularly efficient as it is dominated by retail investors and is too small to be worth the effort for institutional investors.

Of course, funds do have some advantages such as instant diversification. Many preferred CEFs also trade at discounts, though this is less of an advantage than a direct consequence of their high fees. CEFs also have various structural problems such as leverage caps which require frequent forced deleveraging as well as a high cost of leverage at the moment.

While active funds can offer additional alpha, this is not always obvious. For instance, despite being actively managed, few, if any, preferred CEF managers acquitted themselves well during the mid-year banking mini-crisis as they held both Credit Suisse CoCo securities as well as the defaulted bank preferreds such as those from SVB, FRB and SI.

That said, holding funds can have various benefits as well such as occasionally getting access to cheap leverage (such as that of the Cohen CEFs) as well as having stronger potential upside during a rally due to the high level of fund leverage - something we saw most recently.

All in all, it’s perfectly fine to have exposure to both individual preferreds as well as funds as we do in our Income Portfolios. Different types of investors with different levels of market familiarity and goals will make different choices.

Market Commentary

Mortgage REIT Cherry Hill Mortgage ( CHMI ) has authorized a repurchase of up to $50m (40% of total liquidation preference) of its two preferreds (CHMI.PR.A, CHMI.PR.B).

CHMI preferreds have had an extremely low equity / preferred coverage ratio for a long while now (defined as total stockholder equity / preferred liquidation preference, indicating the amount of equity standing behind a dollar of preferreds). This is in large part due to its absolutely hopeless performance which has shaved off a lot of its book value over time.

Naturally the yields on CHMI preferreds were somewhat elevated because of this higher risk profile and this attracted a lot of interest however the risk/reward never made much sense as the preferreds were one crisis away from being in serious trouble.

The buyback of the preferreds will take time - if all $50m is bought back which is fairly unlikely - equity / preferreds coverage would rise to 3.7x - better but still fairly low in the mREIT space. And, of course, by that time book value could drop even further, eroding much of the gain. In the sector, EFC, ABR and TWO preferreds look more compelling in our view.

Mortgage REIT New York Mortgage Trust ( NYMT ) cut the dividend on common shares. The company has been rapidly transitioning from a pure credit mREIT to a mixed Agency / credit REIT. It now has a third of its portfolio in Agencies.

This has a number of positives. One, there is less credit risk embedded in the portfolio which could otherwise be a concern if we do enter a recession. Two, Agencies have remained liquid even through difficult market periods because the Fed has tended to backstop the market with financing. This can allow the company to quickly deleverage at a pinch without running into a deleveraging death spiral.

Overall, the low level of leverage as well as low level of mark-to-market financing is attractive. The stock has 4 preferreds - ( NYMTL ) is the one that’s in our High Income Portfolio. The yield is at the lower end of the suite at 8.9% however it’s expected to step up to the highest level on its first call date in 2026 though it requires a bit of a wait. This should translate in outperformance over the medium term however.

Stance And Takeaways

There are two key indicators relevant for positioning in the preferreds market at the moment. First is the very tight level of credit spreads, proxied below by high-yield corporate bond spreads.

The second key indicator is the fact that the 3-month / 5-year Treasury yield curve is back to an extremely inverted level.

What this means is that today is not a particularly attractive environment to either take a lot of credit risk or take a lot of duration risk. For this reason we plan to lighten on both risk factors and wait for a more opportune time to add risk back on both fronts.

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