TLT - TLT Is Deeply Undervalued To PGX And The Whole Low Current Yield Preferred Stock Market. Again.

2023-06-12 07:30:47 ET

Summary

• The credit spread narrowing is even greater than the one at the beginning of the year.
• Taking TLT long has value added in case of market panic.
• PGX gives an opportunity to take a short position in a group of mispriced securities.

We usually post our articles to members of our service 1 week before we publish them to the public. This article was first published on June 4, 2023.

Credit spread narrowing at the beginning of 2023

Five months into 2023, we are once again in this period of the year when a set of our beloved fixed-rate preferred stocks are trading at historically narrow spreads to their corresponding benchmark treasuries. When a bunch of investment-grade fixed-income vehicles decides to trade as if they are rated a couple of notches higher, there must be a sound financial reason for that, or it is an opportunity for us to engage in a pair trade because of the obvious market mistake. These are pretty much the only two options we have outside of the quantum realm. So let's check it out.

The last time we had this kind of rally in the fixed-income vehicles was at the beginning of this year and was due to the so-called "January effect". The increased demand in January that followed the December tax-loss selling made a set of BBB- and lower-rated perpetuities trade at yields well below 5.5%. At that time, their corresponding benchmark - the risk-free 30-year Treasury bonds - were trading at a 3.6% yield. On top of that, this was a moment we were in a series of continuous Fed Funds Rate increases and a market that was pretty uncertain in general. Credit spread narrowings are way more likely to happen in times when the markets are calmer. Such narrowings of the credit spread of a group of securities give the investors golden opportunities to profit from and we are on a constant search for them.

To cut a long story short, we successfully identified the technical buying in the preferred stocks and the shorting opportunity that it presented while taking ( TLT ) as the long leg. The idea was discussed in depth in our SA trading community Trade With Beta. When starting in March 2023, a number of banks defaulted and the whole banking sector was in crisis, the market realized what risk-free bonds should be, and once our trade mutated from technical into fundamental, it was only a matter of days before it closed. See the members-only article " My largest bet explained " from February 5, 2023, for more information about the setup.

Current credit spread narrowing

Now let us check out what has changed (besides the date, that is) in our small fixed-income universe. At the time of writing this article, risk-free 30-year Treasury bonds are trading at 3.9% and the 20-year ones are at 4% yield.

Since January 2023 were held two FOMC meetings in March and May and on both of them the Fed Funds Rate was increased by 0.25% to 5.25% at the moment. So fundamentally, there is no improvement in the conditions in which fixed-income instruments trade. Yet, following the hype in the AI stocks, there is a group of fixed-rate perpetual preferred stocks rated BBB or lower that trade at yields lower than 5.6%.

More interesting is that most of these stocks that defy sound financial logic are from the banking sector. Even more interesting is the fact that we closed the same pair trade three months ago and now the credit spread narrowing is even greater than the one at the beginning of the year. Our hope is that sector crisis won't be needed this time for this market mistake to be corrected.

Each and every one of the preferred stocks shown above has narrowed its credit spread to its corresponding benchmark. Historically this spread has been steadily around 2.5% at IPO post the financial crisis of 2008-2009 for the average BBB- rated fixed-rated preferred stock. If anyone is interested in sample calculations, they can be found in the article cited above " My largest bet explained ". An investor can short one or some stocks of the group with a comfortable size and take TLT long and that would be a textbook pair trade. But the sophisticated investor might consider taking a short position in all of them, thus gaining some additional benefits:

• Eliminating the possibility to be short-called in a single ticker.
• Eliminating the possibility that a single preferred stock will not widen its credit spread within a foreseeable time horizon.
• Taking advantage of the market mistake for the whole group of mispriced fixed-income vehicles.
• Using a lower borrowing rate compared to a basket of individual stocks.

PGX is a short candidate

The most suitable ETF for the purpose described above, according to us, is the Invesco Preferred ETF ( PGX ).

PGX normally invests at least 80% of its assets in fixed-rate US preferred stocks, and that makes it a perfect candidate for the goal we have. But what about its holdings, are they the ones that are deviated from the benchmark?

Here are the top 30 fixed-rate holdings of PGX. One can check that they sum up to more than 50% of the ETFs' fixed-rate assets. Another thing that can be easily cross-checked is that most of our short picks with historically low credit spreads are among the largest position holdings of PGX. So instead of juggling with a number of positions and their corresponding sizes, an investor could simply take a short position in a portfolio that is better diversified than one could hope for.

We calculated an average weighted CY for the fixed-rated part of the PGX portfolio, so we can be reasonably aware that the yield of the ETF does not deviate drastically from the current yields of the single overvalued preferred stocks we monitor for shorting. Starting from the holdings with the highest weight we have:

These are somewhat normal and expected values. The largest positions in the PGX portfolio are held by investment-grade preferred stocks with large issues. The top 50% of the fixed-rate assets have a yield of 5.78%. Adding smaller positions of high-yielding preferred stocks we get CY of 5.98% for the top 75% of the holdings and 6.27% for the whole fixed-rate part of the portfolio. It is clearly seen that the CY of the fixed-rated part of the PGX portfolio is increasing, as more high-yielding preferred stocks are added. This fact does not represent a problem for our model, as the high-yielders trade at higher credit spreads by definition.

The trade

For the long leg of our pair trade, we take TLT as it is the perfect duration match for the group of mispriced perpetual fixed-rated preferred stocks.

TMF is an even better long pick, with size adjusted accordingly, as it provides the same duration with a smaller dollar value in the position taken:

For the short leg of the trade, there are two options. The trader can short a selection of the group of securities that have narrowed their credit spread or can take a short position in an ETF that has them in its portfolio. As explained in the article, PGX is an almost "perfect match". The most precise way of initiating the trade would be to go long all the stocks from the ETF that make sense with suitable sizing and then short the ETF knowing it is stripped down to the stocks you would like to short.

To give an idea of the potential of the trade we will use the comparison between TLT and JPM-M, as the 2 instruments have pretty similar duration metrics. TLT of course has the benefit of not having convexity issues on the upside. At the moment of writing the yield spread between TLT and JPM-M stands at around 1.3%. The average spread for the JPM family above the 20-year is higher than 2.3%. A simple credit spread widening to what are normal means JPM-M has to trade with a current yield of around 6.2%. This is a price of around $17 for JPM-M or 15% lower than its current price of around $20. To make things even more obvious we post the following chart:

Since the IPO of JPM-M, it has outperformed TLT by close to 15%. The parallel shift in the yield curve decided to not affect this particular preferred stock for any reason. For the last 2 years, the American public has woken up and realized that bank-preferred stocks are far safer than they were 2 years ago. We find this to be a rather suspicious thesis. By implementing this trade we are actually taking the bet that banks are not that much more credible than they were 2 years ago. By buying PGX, PFF, or JPM-M you are betting the opposite, and hopefully everyone realizes that.

Summary

This kind of narrowing of the credit spread of a group of fixed-rate preferred stocks is something that we observe regularly. This alone is the third time in the last year and the second time in 2023 that this market mistake presents us with an opportunity to take positions in such a security-benchmark kind of pair trade. Taking a long position in TLT gives us value added in the case of market panic events. The last time we engaged in this trade, namely the bank sector crisis in March 2023 triggered the sharp drop in yields of the treasuries that had our pair trade closed in a matter of days.

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