WFCNP - Preferreds Weekly Review: The Risk (And Reward) Of Fixed-For-Life Preferreds

2023-05-13 03:38:38 ET

Summary

• We take a look at the action in preferreds and baby bonds through the first week of May and highlight some of the key themes we are watching.
• Preferreds struggled this week under pressure from additional bank tremors.
• Recent news items have highlighted the risk of so-called fixed-for-life preferreds, which we discuss in more detail.

This article was first released to Systematic Income subscribers and free trials on May. 8

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 first week of May.

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

All preferred sectors were down as new bank tremors appeared and broader credit market spreads rose.

This week was even worse for preferreds than what we saw earlier in March just when bank tremors first appeared.

Yields briefly moved above this year's March peak before retracing. Amazingly, preferred yields are not far off what we saw in March of 2020.

However, credit spreads are still fairly well contained, suggesting worries are concentrated only in a small number of issuers.

Market Themes

There were some news items about a potential for having "fixed-for-life" preferreds or preferreds which are expected to move to a floating-rate but may instead keep paying the original fixed rate.

Fixed-for-life as a term does capture the potential scenario here but it's unfortunate because there are multiple fixed-for-life scenarios, some friendly for preferred shareholders and others not.

A fixed-for-life preferred happens if the issuer uses the Libor fallback in the prospectus rather than switches to the SOFR replacement for Libor as many preferreds are expected to do (JPMorgan (JPM) and Citi (C), among others, have already issued press releases saying they will be switching their Libor preferreds to the SOFR rate, keeping the economics pretty much the same as when the stocks were first issued). There are three basic varieties of Libor fallback language. One (used by AHL) just says they will use the previous Libor. This fallback is monumentally unclear because Libor for the previous period will simply not be available as Libor will cease to exist in June.

The second type of fallback used by MS and [[KEY]], for example, is if Libor is not available then just keep paying the original fixed coupon.

The third type of fallback used by [[WFC]] and [[STT]], among others, is to replace Libor with the old fixed coupon and add the spread (as in the new floating-rate coupon of Libor + spread) to it. This fallback is kind of crazy because it double counts the credit spread (the old coupon had the spread baked into it but they are now adding another spread to it which was meant to be added to Libor but is now added to the original fixed coupon).

In short, we would not be surprised if the second fallback issuers kind of stick it to investors and keep paying the old coupon for the simple reason that nearly all, if not all, Libor preferreds with a near-term reset date will step up to a higher coupon if they float. For example, MS.PE coupon would step up to around 9.6% versus the original 7.125%.

That said, it would certainly be odd for these issuers to so boldly go against the spirit of the Libor cessation process just to save a few bucks. Preferreds are not a large component of the capital structure of these issuers - they are around 0.6% of MS liabilities.

It would also be an odd thing to do because the jump in interest expense is likely to be relatively short-lived since the market expects short-term rates to start falling this year. Over the longer term, short-term rates would have to remain significantly above the ~2.8% Libor / SOFR breakeven for MS to save money on MS.PE by keeping the original fixed coupon in place.

That might happen but the market expects short-term rates to be around 3% in the longer-term and the Fed expects it to be around 2.5%. So from a longer-term perspective it's not clear MS will save a ton of money on MS.PE if they keep the original coupon. Clearly, they have other preferreds but their interest rate dynamics should not be a million miles away from this discussion.

Finally, by being a clearly poor market actor, issuers that go down this road could easily raise their interest expense over the longer term as some investors will simply refuse to buy any security issued by them.

On the other hand, we would be very surprised if the third fallback is used because (apart from just being crazy) in that case the coupon will certainly step above the old coupon but also above the coupon had the issuer just used the standard SOFR solution. This is definitely a good time to check those fallback provisions.

Stance and Takeaways

In the context of the above discussion, our view is that it makes sense to tilt away from shareholder-unfriendly potential fixed-for-life preferreds and to tilt to shareholder-friendly potential fixed-for-life preferreds.

The latter category includes soon-to-reset Wells Fargo preferreds (WFC.PQ) and (WFC.PR) whose key details are shown in the table below from our service Preferreds Tool.

WFC.PQ will reset in September of this year (unless redeemed). Our base case is that it does what the other major banks are doing and moves to a SOFR + spread. In this case its coupon will move from 5.85% to around 8.24% (i.e. forward 3m term SOFR of 4.89% + 0.26161% Libor/SOFR basis per the Libor Act + 3.09% spread) to a yield of about 8.9% from today's yield of 6.26%. The yield will then change based on the moves in short-term rates.

If WFC.PQ does the crazy thing of using the Libor fallback in the prospectus, its coupon will become 8.94% and its yield will rise to 9.5%. In other words, in this fixed-for-life / Libor fallback scenario the yield will be 0.6% higher on the first call date than in the base case SOFR scenario.

However, the key difference is that in the fixed-for-life scenario, the yield will be fixed for life (unless the stock is redeemed). This is a big deal because short-term rates are expected to move lower over time. For comparison, fixed yields north of 9% are available in corporate bonds rated roughly B-. WFC.PQ is split rated BB+ / Baa2 or 5 and 7 notches above B- corporate bonds. Having the yield fixed at 9.5% for life (instead of 8.9% which would then very likely move lower over time in the base case SOFR scenario) would be an amazing deal for investors.

Although we wouldn't change a lot of the portfolio around in expectation of a small possibility of an excessive and fixed yield, it can make sense to nibble on these stocks at the margin. And because WFC.PQ (and WFC.PR) look attractive in both scenarios (and the fact that WFC is not caught up in the regional bank storm) there is no downside in our view to holding them in the portfolio. We continue to hold WFC.PQ across our Income Portfolios.

For further details see: