VRP - VRP: Time For A Swap

2023-11-21 23:32:33 ET

Summary

• VRP is an ETF that focuses on preferred equity from financial institutions, but with a twist - its collateral has to be at least 90% invested in floating rate securities.
• VRP has outperformed its fixed rate peer PFF since the beginning of the Fed tightening cycle due to its low duration of 1.93 years.
• PFF is expected to record an additional 9% gain versus VRP as rates move lower given historic correlations and duration impact.
• The Seeking Alpha platform has a very useful TTM dividend yield comparison tool that highlights the historic yield relationship between VRP and PFF.

Thesis

The Invesco Variable Rate Preferred ETF ( VRP ) is a fixed income exchange traded fund. The vehicle focuses on preferred equity from financial institutions, but with a twist - its collateral pool has to be at least 90% invested in floating and variable rate preferred equities. This feature explains the fund's extremely low duration of 1.93 years, and its outperformance in the past year when compared to the much larger and widely held iShares Preferred and Income Securities ETF ( PFF ).

Both funds have financials as their main sectoral allocation (over 70% of the portfolios for both ETFs), explained by the large utilization of preferred equity in the space in order to reduce reported leverage ratios. Financials via their business model run a high amount of leverage, thus preferred equity is a natural way to obtain long-term funding without affecting capital ratios.

The two funds have had almost 1:1 correlation in terms of total return movements prior to the Fed starting its monetary tightening cycle, but duration has played a significant role in the past two years. VRP has outperformed given its 1.93 years duration, versus the estimated 4.4 years duration for PFF:

Since the start of the tightening cycle in January 2022 PFF has lost -22.85%, while VRP has lost only -13.62% price-wise. The gap that has opened up is mainly driven by the interest rate sensitivity for the two funds, since from a credit standpoint PFF contains almost similarly rated collateral (both funds have over 50% BBB-rated names in their composition, with VRP faring better).

While VRP has outperformed while rates were moving higher, it will do the opposite when rates move lower on the back of Fed cuts. In this article, we are going to explore why it makes sense to swap out of VRP and into PFF for retail investors, given the additional 9% that can be obtained from running an increased interest rate risk via PFF.

Historic correlation

In a normalized interest rate environment where rate volatility is low, the two funds have a very high total return correlation:

We can see the two funds having a matching total return up to January 2022 when the Fed started raising rates. A non-volatile interest rate environment allows for the duration and yield mismatches to catch up to each other, creating a well-correlated total return.

The sudden and significant rise in interest rates in the past two years has resulted in interest rate duration making a significant dent in PFF's returns, while VRP has been affected less given its low 1.93 years duration. Going forward, as rates move down, the opposite will occur - PFF will outperform and close the total return differential gap:

SOFR futures are currently pricing a 100 bps move lower in this short-term rate for 2024, with short rates expected to move below 4% into 2025. PFF is set to gain 4.4% for each 100 bps of moves lower in rates (we are assuming a parallel shift in the entire curve for the purpose of this analysis - i.e. the front, 2y and 4y nodes will shift by the same amount). Conversely, VRP will only gain 1.9% for each 100 bps of monetary loosening. As a reminder, SOFR represents the Secured Overnight Financing Rate and represents a broad measure of the cost of borrowing cash overnight collateralized by treasury securities. SOFR is the replacement for Libor, and an active market exists for SOFR futures , where investors can gauge market probabilities for future rate levels.

Collateral composition

VRP has been helped during this monetary tightening cycle by its collateral pool, which is mostly floating rate:

The Invesco Variable Rate Preferred ETF is based on the ICE Variable Rate Preferred & Hybrid Securities Index (Index). The Fund will generally invest at least 90% of its total assets in floating and variable rate investment grade and below investment grade U.S. dollar denominated preferred stock and hybrid debt publicly issued by corporations in the U.S. domestic market. The Index is designed to track the performance of floating and variable rate investment grade and below investment grade U.S. dollar preferred stock.

The same way leveraged loans have outperformed in 2023, VRP has managed to navigate very well a tough fixed income environment. Let us have a look at one of its components, to better understand why:

The fund holds 0.98% of its portfolio in the Bank of America 060505EH3 Cusip, which is a preferred stock issued by the financial institution. The perpetual security has the following characteristics: '6.250% to but excluding Sep 5, 2024; 3-month LIBOR + 370.5 bps thereafter'. This translates into the holding switching to a floating rate starting in September 2024. As opposed to a preferred stock that is fixed rate into perpetuity, this security will have a much lower duration due to its floating rate features. When discounting the security, a move higher in floating rates will result in the security displaying higher future coupons, thus a better price when utilizing an NPV function.

As mentioned before, the fund is mainly focused on financials securities:

Energy and utilities are the next two largest sectoral exposures for this fund.

Yield considerations

VRP currently has a twelve months trailing yield of 6.53%, versus 6.99% for PFF:

The above table and functionality can be found on the Seeking Alpha platform and represents a very nifty feature to compare historic yields. A retail investor needs to go under the 'Dividends' tab and then click the 'Dividend Yield' sub-tab.

The levels are very close for the two funds but do expect VRP's yield to decrease faster when rates move down, while PFF's fixed rate underlying feature will translate into price gains for the fund as rates move lower.

Conclusion

VRP is a robust fund that has benefited from its variable rate collateral in 2023. The ETF's price is virtually unchanged on the year, with a total return north of 6.4%, coming almost exclusively from its dividend yield. The fund invests in preferred equity from financial institutions and has a very low duration of 1.93 years.

This feature has allowed the fund to outperform its fixed rate peer PFF since the beginning of the Fed tightening cycle. The current price differential from the duration impact is 9%, and while VRP has been the beneficiary during higher rates, PFF will record that additional gain versus VRP as rates move lower.

Both funds have similar collateral from a fundamental perspective, owning financials preferred equity, mainly investment grade (over 50% of the portfolios are rated BBB). A retail investor currently long financials preferred equity via VRP will get an additional boost via PFF from interest rate duration in 2024 as rates move lower. We are therefore of the opinion that a swap is appropriate at this stage, by selling VRP and buying into PFF.

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