WFCNP - Preferreds Weekly Review: Term Preferreds Yields Aren't Well Understood

2023-07-29 10:38:08 ET

Summary

• We take a look at the action in preferreds and baby bonds through the third week of July and highlight some of the key themes we are watching.
• Preferreds mostly rallied on the week as credit spreads continued to tighten in line with the soft landing narrative.
• Term preferred yields remain opaque to many income investors, resulting in inefficient pricing and opportunities.
• We highlight a new preferred from CEF EIC as well as a portfolio rotation.

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 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 July.

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 were mostly higher this week despite slightly higher Treasury yields as credit spreads continued to grind tighter. Higher-beta mREIT, BDC and Tech sectors are in the lead so far this month. Sector returns are around 5% so far this year, despite higher longer-term Treasury yields.

Yields have fallen back from the March bank tantrum period but remain north of 7%.

Market Themes

In the Market Commentary section below, we highlight a new term preferred. There are not very many term preferreds so this feature is somewhat unusual. Term preferreds don't appear to be well understood by income investors for a couple of reasons.

First, not many investors are aware which preferreds have maturities (i.e. which are term and which are perpetual preferreds) and two, even if they are aware, they are not always adept at calculating the yield-to-maturity of a term preferred.

This means that the term preferreds sub-sector is often not very efficient and can trade at very attractive yields, as most investors make allocation decisions on the basis of stripped yield rather than yield-to-maturity.

For example, the chart below shows two preferreds from the CLO CEF Eagle Point Credit Co ( ECC ). Notice that [[ECCC]] has maturity, while [[ECC.PD]] does not.

The chart below shows the yields of the two preferreds. The yield-to-worst or YTW is the key metric to focus on. For a term preferred, the YTW is just the minimum of the yield-to-maturity and the yield-to-call. For a perpetual preferred, the YTW is the minimum of the stripped yield and yield-to-call. Because both stocks trade below $25 the ECCC YTW is its YTM and the ECC.PD YTW is its stripped yield.

What we see is that while on a stripped yield basis the yield differential is about 0.43%, on a YTW basis it is 1.04%. In other words, the two preferreds are trading much more on a stripped yield basis than on the correct YTW basis. Moreover, on a stripped yield basis, ECC.PD looks more attractive by 0.43% whereas in reality ECCC is more attractive by 1.03%.

In our view, a preferred with maturity is significantly more attractive than a perpetual preferred because the company is required to redeem the preferred on the maturity date. In this sense, the preferred acts similar to debt and provides investors with additional protection. Moreover, a maturity limits the duration and overall beta of the term, preferred over its perpetual counterparts.

Between the two stocks it seems obvious to us that ECCC with a maturity and a higher yield is the one to go for, however, many investors implicitly disagree. The question is how many of them are aware of the maturity difference and the right yield figures.

Market Commentary

CLO CEF Eagle Point Income Fund ( EIC ) is issuing a new term preferred EICB. The stock will have a 7.75% coupon and a 2028 maturity with a first call date in 2025. The fund EIC has an existing preferred EICA trading at a yield of 7.15% so a rotation to EICB looks attractive for EICA holders.

CEFs preferreds remain very attractive for a number of reasons. One, they tend to be term preferreds which limits their volatility and ensures, in the absence of default, that they return $25 at maturity.

Two, CEFs are much easier to think about than traditional companies because they are just wrappers of securities. A CEF cannot lose a key customer, have a supplier jack up prices, commit fraud - things that happen to "normal" companies.

At the same time, however, the yields on these tend to be pretty good. The market also doesn't do a very good job differentiating between them. For example, EIC has an advantage over the CLO Equity preferreds from ECC, [[OXLC]], [[OCCI]] and Priority Income Fund in that CLO Equity is in the minority of its portfolio, which means it's going to be much more resilient in a crash.

Stance And Takeaways

This week, we made a small adjustment in our Defensive Income Portfolio. The Wells Fargo Series Q ( WFC.PQ ) position is very likely to be redeemed in September. For this reason, it was rotated to a high-yield Muni mutual fund and the term preferred CEF ( JPI ).

The rotation adds duration to the portfolio, which is attractive in an environment of relatively high level of nominal and real long-term yields and tight credit spreads. JPI remains a very compelling term CEF opportunity given its 6% discount is likely to close over the next year.

For further details see: