A few ideas for returns above 8% to take advantage of rising short-term rates
One of the most significant developments in the income market in recent months has been the interrelated dynamics of relatively persistent inflation, an increasingly hawkish Fed, and the associated sharp rise in short-term rates.
In this article, we highlight the preferred securities that should benefit from this sharp rise in short-term rates. To do this, we identify attractive securities with reset yields. Investors who want a quick refresher on the different types of preferred stock returns can check out our previous article.
Quick Reset Performance Review
A reset yield is simply the expected stripped yield of the stock on its first call date when its coupon switches to a floating rate, if it is not redeemed by the issuer. For example, Zions Bancorporation 6.3% Series G (ZIONO), which trades at a stripped price of $25.22, has a fixed coupon of 6.3% that transitions to 3-month Libor + 4.24%, s it is not reimbursed in March 2023.
This is what the market expectation should be for the 3 month Libor.
To calculate ZIONO’s reset yield, we first need to see what the floating rate coupon should be on the first call date of the stock (i.e. when the coupon first crosses to a variable 3-month Libor rate + 4.24%) . The 3-month Libor should be around 3.2% at this time (this is based on “forward libor” – a standard method of calculating market estimates of interest rates going forward) . So we simply add the Libor estimate of 3.2% to the spread of 4.24% to get a coupon of 7.44%. A coupon of 7.44% in March 2023 on a stripped price of $25.22 is equivalent to a stripped yield of 7.38%, which is ZIONO’s reset yield.
A few caveats
Four points are worth emphasizing here. First, the 7.38% is by no means guaranteed for two reasons. First, the real 3-month Libor in March 2023 could very well be different. Libor futures simply provide unbiased estimates of what future Libor should be based on the current shape of the yield curve. If the actual Libor is lower, the reset yield will also be lower and vice versa.
Second, equity coupons will change over time as the Libor changes. This means that even if the currently expected Libor of 3.2% in March 2023 is correct, it will invariably change as market expectations for the Fed’s policy rate change and the Fed itself changes its policy rate in response to macroeconomic conditions. The graph below shows what ZIONO’s performance looks like before the first call date (the flat line before the black dot) and after the first call date, if it is not redeemed. The yield after the first call date rises as the coupon is expected to rise from 6.3% to 7.44% and falls as the Libor is also expected to fall.
Third, investors should exercise caution when comparing reset yields, as different first call dates correspond to different levels of Libor futures. For example, if ZIONO had a first call date in March 2024 rather than March 2023, its reset yield would be significantly lower for the simple reason that the Libor in March 2024 is expected to be significantly lower than in March 2023.
And finally, the stock could be redeemed by the issuer before the coupon floats. We discuss this point in a little more detail below.
We start by identifying the larger pool of potentially attractive stocks from our investor preference tool by first selecting preferred stocks with less than 2 years on their first call date (because there is little reason to look at a preferred 2028 first call date as we can have no confidence what short-term rates will be at that time) and reset yields above 6%.
The scatter plot below shows these stocks. The y axis shows the reset yield and the x axis shows the worst case yield (i.e. the yield leading up to the first call date).
Within this population we will highlight the following titles:
- K1 MLP DCP Midstream Issuer 7.875% Series B (DCP.PB), is trading at a stripped price of $23.42 with a reset yield of 8.41% YTW / 8.88% with a first redemption date in June 2023.
- K1-issuer MLP Energy Transfer 7.375% Series C (ET.PC), trading at a stripped price of $23.15 with a reset yield of 7.97% YTW / 8.49% with a first redemption date in May 2023
- mREIT AAIC 8.25% Series C (AAIC.PC), trading at a stripped price of $24.49 with a reset yield of 8.42% YTW / 8.92% with a first redemption date in March 2024.
- mREIT CIM 8% Series B (CIM.PB), trading at a stripped price of $24 with a reset yield of 8.34% YTW / 9.24% with a first redemption date in March 2024.
On the premium side, we also like:
- California Utility SCE 5.75% (SCE.PH) is trading at a stripped price of $22.9 with a reset yield of 6.3% YTW / 6.62% with a first call date of March 2024.
- Zions Bancorporation 6.3% Series G (ZIONO), trading at a stripped price of $25.22 with a reset yield of 5.33% YTW / 7.38% with a first call date of March 2023.
In the event of redemption, the yield-to-call of these securities is at least as high as their YTW (yield-to-worst defined as the minimum of the stripped yield and the yield-to-call). For securities trading below $25 in terms of stripped price, the yield on redemption is higher than the YTW mentioned above.
What if they were simply redeemed?
A common criticism of Fix/Float securities is that they may be redeemed before the holder can take advantage of the switch from a fixed rate coupon to a floating rate coupon, foregoing the potential yield increase.
First of all, that’s not necessarily true. Just because a stock’s floating rate coupon reaches a higher level than its fixed rate coupon does not mean the issuer will automatically redeem the stock. This is because the issuer will always have to refinance the stock (few issuers will have tens of millions of dollars of reserve currency lying around), and refinancing costs aren’t cheap. And second, because a company that refinances from a variable rate coupon to a fixed rate coupon loses the potential benefit of a lower coupon once the Fed begins to cut rates (in the scenario where the economy goes into recession, for example).
Second, with many preferred stocks trading below their liquidation preference (typically $25), this means that a redemption would be a good outcome for investors since the yield on redemption is often very high. For example, the call yield or YTC of DCP.PB is 13.72% while its reset yield is 8.88%. All but one of the stocks mentioned above have a redemption yield greater than its YTW or yield at worst. And while it’s true that YTC is unique, it can still provide additional returns to reallocate to other attractive stocks in circulation to increase compound returns.
That said, it is clearly possible for the issuer to redeem the stock – the issuer is within their rights to redeem the security after its first call date (i.e. when the coupon has changed from fixed to floating). However, this has the obvious side benefit that it will keep the price of the favorite much more resilient until the first call date and, probably, not so far below $25 than it otherwise would be. There are many examples of good quality fixed rate preferred stocks that lack this feature and are currently trading more than 20% below their level at the end of last year. In short, even if holders do not benefit from the floating rate coupon, they do benefit by having their capital allocated to a more resilient security.
Finally, it’s important to point out that Libor is going away – interested readers may want to revisit our recent take. The key point is that the economics of the floating rate coupon should remain roughly the same even if the underlying base index moves to SOFR.
Take away food
High reset preferred stocks remain attractive in the current market environment characterized by persistent inflation, a hawkish Fed and rising short-term rates. These stocks can offer potentially attractive returns if the reality of future short-term rates is close to current expectations. They may also prove more resilient relative to their fixed-rate counterparts in investors’ portfolios, anchored by the possibility of redemption and high floating-rate coupons after redemption. Judging by the basic makeup of the preferred stock space, most preferred investors are overweight fixed rate preferred stocks and the stocks mentioned in this article can offer a good dose of upside income and diversification in the market. current market environment.
One risk to keep in mind is that the Fed tightens excessively, causing demand to weaken significantly, pushing the US economy into recession and leading to lower inflation. This will likely cause the Fed to cut its key rate toward zero, which will cause reset yields to drop significantly before investors can take advantage. Therefore, in our view, high reset Fix/Float securities should be held alongside longer duration fixed rate securities which should benefit from this scenario.