Favorite Weekly Review: Duration Stabilization Brings Some Relief
This article was first published to Systematic Income subscribers and free trials on April 30.
Welcome to another installment of our Preferred Markets 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 historical context as well as relevant themes that seem to be driving the markets or that investors should be aware of. This update covers the period up to the last week of April.
Be sure to check out our other weekly updates covering BDC as well as CEF markets for insights across the entire revenue space.
Preferred shares had another week of declines, with April being the worst month for the preferred share sector since March 2020. And while Treasury yields, for once, were relatively flat over the week, the Falling equities and rising credit spreads were a drag. The area.
Since the beginning of the year, only the energy sector remains in the green.
Looking at the yield differential between preferred stocks and Treasuries, we see that it has come out of the very low level of mid-2021. At the same time, we cannot say that the sector is obviously cheap as there is much more room for credit spreads to widen even if we declare the COVID period special.
It’s also interesting to note that most of the retail fund selling was in passive ETFs, while active ETFs actually added assets starting in the third week of April. This flight of assets has clearly exacerbated the volatility of the sector. Unless prices recover over the next two quarters, we wouldn’t be surprised to see further weakness due to tax-loss sales.
Many preferred investors are familiar with the concept of negative convexity which many investors internalize as preferred stocks offering less upside and more downside. The technical definition of convexity is a bit different and has to do with the rate of change in duration given changes in yields, duration itself being defined as the change in price for a small change in yield.
A typical bond has positive convexity – its sensitivity to rate changes decreases when its price falls (i.e. when yields rise) and its sensitivity to rate changes increases when its price rises (i.e. say when yields fall). Another way of saying this is that when the price of the bond goes down, its price goes down faster and slower as yields go up and as the price of the bond goes up, it goes up faster and faster as yields fall. This is an attractive feature of bonds.
Callable preferred shares have negative convexity, so they work the other way around. For preferred stocks that trade near their “par” level, their price falls faster as yields rise and their price rises more slowly as yields fall. Intuitively, this makes sense – as yields fall, the upside momentum of the preferred stock will be increasingly constrained by its call function. That’s why you don’t see a lot of callable preferred securities trading much higher than their “par” level.
Readers who prefer graphs can check out the one below which shows the price behavior of a non-callable bond and a callable bond (i.e. callable preference). You can see how the callable bond’s price gains slow as yields fall and accelerate (to a point) as yields rise.
The current market environment for preferred shares is good/bad news. The bad news is that their sensitivity to interest rates or duration has lengthened considerably, from around 4.3 at the start of 2021 to 7. The good news for preferred investors is that negative convexity has decreased considerably. We can see this in the red line in the chart below.
In short, the sensitivity of preferred stocks to further interest rate hikes is high (the black bar is relatively high) but it won’t increase much more (because the red line is closer to zero). In short, the pace of price declines will not increase much more from here, i.e. while prices will likely fall if Treasury yields continue to rise, they will no longer accelerate on the way down.
Overall, the rise in yields plus this stabilization in duration, combined with the fact that higher credit spreads have more room to absorb further increases in Treasury yields, means that the sector is more attractive at the moment than it is. was only in the second half of 2021.
During the second half of last year, we repeatedly discussed in our weeklies how unattractive the general environment for preferred shares was by pointing to the chart below when the market yield at 25 per was lower at 4%. Stripped-yield investors probably haven’t noticed this dynamic, because stripped-yield is much less sensitive to changes in yields and doesn’t provide a proper valuation picture.
Now that the sector’s performance is near the upper end of its 5-year range, it offers a much better environment to put new capital to work for investors who have remained patient.
It was a big week for earnings for mortgage REITs whose preferred share sector is quite large with more than 50 stocks.
Armor Residential REIT (ARR) released dismal numbers – book value was down 18%, reflecting the significant drop in agency assets versus Treasuries i.e. a broadening of the MBS base which we can see in the graph below from Annaly.
Remember that this, unlike duration or even negative convexity, is something that mREITs don’t cover (EFC is perhaps an exception that actually partially bypasses TBAs), so they support all the weight of this dynamic. From a preferred equity perspective, the issuance of $54 million of common stock helped support equity/preferred equity coverage which fell to 6.0x from 6.7x. ARR has historically issued additional preferred shares, but they seem to have stopped doing so in the past year, which has helped. Leverage increased from 7.5x to 7.0x. ARR also increased its position in Treasuries from 2% to 15%, which helped contain the decline in book value. (ARR.PC) is a fixed rate stock and is trading at a yield of 7.31% with a total return of -4.3% year-to-date. The portfolio’s risk profile remains reasonable although management has not been particularly confident in protecting book value during drawdown periods. Annaly (NLY) reported a 15% decline in book value for the same reason as ARR. Equity/preferred equity coverage fell to 7.5x from 8.6x while leverage increased to 6.4x from 5.7x. Recall that NLY sold its $2 billion mid-market loan book to Ares to focus more on the housing finance business. Of the three preferred suites, (NLY.PF) looks the most attractive based on the forward yield profile below.
Dynex Capital (DX) managed a book value increase of 1.4%, largely attributed to its low leverage and low coupon MBS position which are relatively rare. Equity/Preferred Cover increased from 6.9x to 7.0x and Leverage increased from 5.8x to 6.1x. Recall that DX also navigated exceptionally well through the COVID crash, reducing its leverage far more than other mREITs.
Overall, it’s clear they’ve been the most nimble MREITs when it comes to market positioning and got it right at key turning points. DX.PC recently traded as low as 6.62% YTW and we wouldn’t chase it here – we’ve changed our ‘Buy’ to ‘Hold’ rating now on the stock that remains in the Basic Income Portfolio .
Position and takeaways
The current environment of 1) quite attractive risk-free rates, 2) still tight credit spreads and 3) rising recession estimates means that some of the higher quality longer duration assets are becoming attractive.
These include some of the favorite low coupon banks such as (BAC.PQ), (COF.PN), (JPM.PL) and others all close to yields of around 6%, as well as some bonds for longer term babies like the United States. Cellular (UZE) at 7%.
The idea is that in the next recession, lower-quality securities will underperform because their credit spreads generally widen more than risk-free rates fall. Higher quality stocks see credit spreads widen much less, meaning they can either stay roughly flat or even recover in a recession. Having some exposure to these securities can provide a useful source of “dryer powder” to allocate to higher yielding assets once credit spreads start to widen.