PFF - Preferreds Weekly Review: Pinned-To-Par Stocks Have Performed As Expected

Summary

• We take a look at the action in preferreds and baby bonds through the fourth week of August and highlight some of the key themes we are watching.
• Preferreds finished the week lower as Powell disabused the market from a drop in the policy rate over 2023.
• Pinned-to-par stocks have performed as expected through the sharp drawdown this year - offering local resilience but unable to withstand very high volatility.
• We also highlight the quarterly release from mREIT AAIC as well as a number of recently issued baby bonds.

This article was first released to Systematic Income subscribers and free trials on Aug. 24.

Welcome to another installment of our Preferreds Market Weekly Review, where we discuss preferreds and baby bond market activity from both the bottom-up, highlighting individual news and events, as well as 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 fourth week of August.

Be sure to check out our other weekly updates covering the BDC as well as the CEF markets for perspectives across the broader income space.

Market Action

Preferreds finished the week lower along with nearly all other income sectors as Powell clarified that the Fed was likely to keep rates higher for longer. This, as we pointed out recently, was a significant risk to the market given the consensus view that the Fed would start to move rates lower in 2023.

Retail preferreds saw significant volume as the chart below shows for the largest preferred ETF ( PFF ). Volume on one day this week was even higher than during the sharp sell-off in June. Institutional preferreds, as proxied by FPEI , didn't move as much and volume was moderate. The highly volatile performance of the sector is keeping retail investors on edge.

The recent back-up in Treasury yields has hurt the higher-quality / lower-coupon stocks such as those in the Banks and Insurance sector.

The Bank sector median yield is now not far from a 6% yield level once again.

The spread over Treasuries has not risen as much and remains around 2.5%. A rise to a 3% level will make higher-quality preferreds very attractive in our view.

All-in-all preferreds have given back some of their recent rally but are not yet trading at the very attractive levels we saw in June, suggesting investors don't need to chase stocks in this range-bound environment.

Market Themes

There are many top-down allocation criteria that we have been highlighting over the past year which drive the performance of the preferreds sector. Apart from the typical credit quality and sector, important criteria include coupon/yield level (e.g. high vs. low), coupon profile (Fixed vs Fix/Float), term vs. perpetual, pinned-to-par vs. not and many more.

Pinned-to-par preferreds are simply those that are either currently callable or will very soon become callable by the issuer and which are trading around their liquidation preference (typically, $25). This prevents the stock from rising much above $25 as that could lead to an immediate loss for investors on redemption. For this reason the stock remains "pinned" to $25.

The term pinned-to-par is not a great one, however, because it implies that the stock is universally more resilient than stocks that are not pinned-to-par. However, this is not the case. As we highlighted in the previous article,

...these securities are often locally resilient to higher rates and wider credit spreads. We say locally because, for large enough rises in yields, the prices of these securities are not going to defy gravity and they will move lower. But, for marginal rises in yields, they can maintain resilience.

Pinned-to-par preferreds can be locally resilient because these securities tend to trade at a higher yield than non pinned-to-par securities from the same issuer for the simple reason that their prices cannot rise for fear of redemption. This lower price (lower than it would be if it were not dragged down by the chance of redemption) mechanically results in a higher yield. This resilience lasts only so long as there is a yield cushion between it and other preferreds of the same issuer. If market yields jump higher so that this cushion disappears, pinned-to-par preferreds can become unpinned very quickly and behave like any other preferreds.

If we take a look at year-to-date total returns of pinned-to-par preferreds relative to their sectors, what we find is that they have indeed outperformed but in many sectors that outperformance is marginal. This very much has to do with our earlier comment that the expected outperformance is mostly local, i.e. for small moves in yields. Once yields jump sharply as they did this year then all bets are off. This marginal outperformance is explained by how much it takes for the pinned-to-par yield cushion to erode and that can be a small market move indeed.

Market Commentary

Mortgage REIT Arlington Asset Investment ( AAIC ) completed a sale of 371 single-family properties (out of a portfolio of 586 valued at $182m) for $130m. This should increase book value by $0.50 per share or around 7% and raise equity/pref coverage to 6.3x from 5.9x.

This derisking, coupled with very low leverage plus a very high-quality remaining portfolio (primarily agencies) and very high yields on preferreds (AAIC-C at 9.8% stripped yield to 2024) and high yield on the debt (2025 AIC at 7.4% yield) makes it attractive.

Equity is decreasing as the company is buying back stock (which remains way below book value) as a way to return capital to investors so it’s not ideal for preferreds or bonds but it’s not critical.

There are not many mREITs that have delivered higher book value for the last 4 quarters (granted some of it is on the back of not paying the common dividend but even if a dividend was paid book value would have still outperformed nearly all other mREITs).

All of that said, AAIC is clearly somewhat of an oddball. They continue to not pay dividends on the common although on the call Rock Tonkel mentioned the Board was discussing reinstating it at some point. Overall, it remains a kind of one man Rock Tonkel band so that carries some clear risk.

A few bonds were added to the Baby Bond Tool. The 6% 2027 bond ( SAT ) from Saratoga BDC is trading at a 7.4% yield. With a 2027 maturity it’s fairly attractive in the sector.

The 5.95% 2062 bond ( PRH ) from Prudential is the newest of their 3 bonds. At a yield of 5.8% it’s on par with PRS and reasonably attractive for an investment-grade issue. The very long 40-year maturity is an obvious risk – there are other shorter-dated baby bonds (though with a lower rating) at a similar or higher yield. That said, it always makes sense to have some higher-quality long-duration options in the portfolio (recall the All-Weather concept) which can outperform in a typical recessionary kind of market where credit spreads rise and Treasury yields fall.

Finally, the 8% 2027 bond ( SCCG ) – the latest bond from mREIT Sachem Capital - started trading just north of 8% yield. It looks the most attractive in the suite. Investors who want to shorten up on duration even more may want to go with the 7.74% yielding ( SCCB ) which has less than two years to go till maturity.

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