2023-07-16 18:00:00 ET
Summary
- We had a buy rating on the Energy Transfer Preferred shares on the last coverage.
- Current interest rates plus 1-2 more rate hikes will push yields into double digits.
- We tell you why we stepped out.
On our last coverage, we gave a hold rating to Energy Transfer LP ( ET ) and instead suggested investors could seek income in the preferred shares, specifically Energy Transfer LP 7.60% CUM PFD E ( ET.PE )
ET.PE also gives you a very solid upside in case we get what we call a passive aggressive Fed. That would be a Federal Reserve that stops hiking right away but refuses to cut despite GDP weakness as inflation pressures remain strong. Such a scenario could see ET.PE getting called in one year, netting 17.5% returns ($1.90 in distributions plus $2.10 upside to par, on $22.90 investment). While we don't believe anyone should hitch all their hopes and dreams on a passive aggressive Fed, we think having some plays that benefit in such a scenario should make up part of a fixed income portfolio. We have ET.PE for that.
Source: A Bet On A Passive-Aggressive Fed
Since that update, ET.PE rallied by over $2.00 a share. Energy Transfer LP 7.625 PFD UNIT D ( ET.PD ) rallied by about $1.80 and Energy Transfer LP 7.375% PFD SR C ( ET.PC ) rallied by about $1.40. We go over our outlook now and tell you why we exited ET.PE at $24.83.
Call Probability Moving Up
ET.PC is the first in line for potential redemption/call by the company. We are past the call date of 5/15/2023. The float will be at three-month LIBOR plus a spread of 4.530% per annum. There is considerably uncertainty on the LIBOR /SOFR switch until the company itself clarifies what it plans to do. We have not come across any specific communication from ET on this but one should be coming pretty soon. The key considerations here are the relative cost of equity and debt. Preferreds occupy a hybrid position between debt and equity and should ideally be midway between the two. ET's longer dated debt is yielding around 6.39%.
ET's common is yielding around 9.5%. So preferreds should cost the company around 7-8%. With the hike in play for next Fed meeting, we are looking at near 10% for ET. On the surface, redeeming this should be a no-brainer for ET. The question will be whether this changes the equity debt ratio enough to reduce favorability with rating agencies. Since these get a part equity credit, generally redeeming them will be credit negative. In this case, we think the amount is very small ($450 million of par value) in context of ET's market capitalization and enterprise value.
Our bet is that this will be called very shortly. ET certainly has the free cash flow to do it. Yes, there are MLPs out there like NuStar Energy L.P. ( NS ), paying well into double digits on its preferred shares. But even they are redeeming their most expensive preferred shares to the extent they can.
ET.PD
This one will float with an even higher spread (4.738%+LIBOR) in one month. That would be an ideal time to announce both (ET.PD and ET.PC) to be redeemed. For both these units, holding on till redemption looks ok to us. It appears like a great yield for "cash parking", although there are some small risks.
Why We Exited ET.PE
When we first chose ET.PE as our preferred entry in this space, we were one of the rare bulls on interest rates. We felt that an aggressive Fed and relatively near term (around 2 years) reset, would underpin values. ET.PE did indeed outperform all fixed rate preferred shares that we follow over this timeframe by delivering an 8.51% total return. iShares Preferred & Income Securities is down 13.56% and 6.52% including distributions.
Virtus InfraCap U.S. Preferred Stock ETF ( PFFA ) is another popular ETF for the preferred space and it too delivered negative total returns over this timeframe.
But what we got wrong was that the interest hike cycle was even more aggressive than what we envisioned. This caused both ET.PD and ET.PC to outperform ET.PE as they ran into earlier reset dates. This leaves ET.PE is a no man's land. Holding another year runs into an symmetrical situation. If rates stay high or go higher, we get redemption. So our upside is small. Not immaterial, considering there is some accrued distributions built into the $24.83 price, but still small. But what if we do run into the next rate cut cycle and it turns out to be aggressive? You could see floating preferreds really butchered in that cycle. The risk-reward is just not compelling. If we want 7.5% returns with virtually zero risk , we can get it. ET.PE does not provide that. It provides about 8.5% upside in one year including distributions and an asymmetrical downside risk which could be really big.
Verdict
We closed out our trade here and it wasn't the best entry or even the best choice amongst the ET preferreds. It still did ok and beat the PFF and PFFA by a wide margin.
Enhanced Equity Income Solutions
At this time our strategy is to slowly increase fixed rate preferred shares into progressive weakness. We want quality credit and we want them to be "cheap" on a relative basis even if we see extended 5.5% Fed Funds rates. We have started getting a few names that meet these criteria and suspect we will get a lot more in the months ahead.
Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
For further details see:
Energy Transfer: Redemption