EICA - Preferreds Weekly Review: Term Preferreds Deliver On The Promise

2023-12-03 05:04:27 ET

Summary

• We take a look at the action in preferreds and baby bonds through the fourth week of November and highlight some of the key themes we are watching.
• Preferred stocks have given back some of their month-to-date returns, but all sectors remained in the green in November.
• Term preferreds, with lower duration and attractive yields, have delivered positive returns since the rise in interest rates in 2022.
• CCIA - the newly issued preferreds from CLO CEF CCIF - remain relatively expensive.

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 fourth week of November.

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 have given back some of their performance this week, however all sectors were in the green through November. 10Y Treasury yields, which exchange-traded preferreds are highly sensitive to, are down 0.4% so far through the month, supporting prices.

The yield of the median exchange-traded preferreds bounced off a very attractive 8% level recently and settled in around 7.5% or so. This is still attractive in an environment of the Fed likely having ended its hiking cycle and still high real rates.

Current yields are on par with the COVID peak; however, the composition of the yield is very different. While at the COVID peak we saw a combination of very low Treasury yields and very wide credit spreads, this time around we have a combination of high Treasury yields and fairly tight credit spreads.

In any case, this combination is much better for allocating to the sector than the environment we saw in 2021 which combined very low Treasury yields and tight credit spreads.

Market Themes

As most income investors know, preferred shares are almost always issued as perpetual securities. Term preferreds, or preferreds with a maturity date, don't get much focus in preferreds allocation. This is mostly due to the fact that there are few of these securities. In our database, we count 43 out of 670 preferreds as being term preferreds.

These term preferreds are composed of two types of securities - trust preferreds and native term preferreds. Trust preferreds are trusts that hold a bond from a given issuer that is then repackaged within the trust and sold as a preferred. Trust preferreds are on their way out as they have been phased out by post-GFC regulation.

Native term preferreds are preferreds that are issued as preferreds with a maturity. Nearly all of these securities are issued by CEFs, particularly CLO Equity CEFs.

Term preferreds have been an important part of our Income Portfolios for several reasons. One, their much lower duration vs. perpetual preferreds makes them lower-beta in a period of shifting interest rates. And two, their yields don't typically reflect this lower-risk feature, creating a very attractive absolute and risk-adjusted yield profile.

As the chart below shows, since the rough start of the back up in interest rates in 2022, term preferreds have delivered a positive total return whereas the majority of the preferred sectors are still well in the red.

Within term preferreds, a couple of decent options with a lower credit risk profile are the Eagle Point Income Company ( EIC ) preferreds EICA and EICB as well as the XAI Octagon Floating Rate & Alternative Income Term Trust ( XFLT ) preferred XFLT.PR.A , which are trading at yields of 8-8.3%.

Market Commentary

The preferred CCIA issued by the CLO Equity CEF Carlyle Credit Income Fund ((CCIF)) is now trading and has been added to our Preferreds Tool. The yield is around 8.2% which is not very attractive. Other CLO Equity CEF preferreds are trading at significantly higher yields - some PRIF preferreds are north of 10%, ECC and OXLC preferreds are around 9% and OCCI preferreds are around 9.5% yields.

The chart below shows that CCIA is priced as a lower-risk preferred (i.e. a preferred issued by a fund like EIC and XFLT that has a lower risk profile with a lower allocation of CLO Equity) despite being a higher risk CLO Equity fund. We see better value in something like PRIF.PR.F which enjoys a much higher yield despite a similar risk profile.

Stance And Takeaways

Although limited duration securities like term preferreds continue to have their place in the portfolio, today's environment of high nominal and real rates creates a significant margin of safety for terming out the duration profile of an income portfolio.

In other words, it can make a lot of sense to use the more stable capital base provided by term preferreds over the last couple of years to allocate to longer-duration preferreds. These fixed-rate preferreds, particularly in higher-quality pockets of the sector, can outperform in a recessionary and/or disinflationary environment of lower longer-term interest rates.

For further details see: