Yield to Worst

Preferred Market Weekly Review: Suspension of OTC Dividends

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This article was first published to Systematic Income subscribers and free trials on January 8th.

Welcome to another installment of our weekly preference market review where we discuss activity in the preferred bond and baby bond market both from the bottom up, highlighting individual news and events, as well as top to bottom, providing insight into 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 first week of January.

Be sure to check out our other weekly updates covering BDC as well as CEF markets for insights across the entire revenue space.

Market overview

The preferred stock market continues its “fat and flat” sawtooth stock pattern. While December’s Santa Rally had the best monthly performance since June of last year, January has been a disappointment so far.

Systematic Income - Preferred Average Monthly Returns

Systematic income

So far, the main theme of the year has been the relentless rise in Treasury yields. Every trading day of the year has brought higher long-term yields and the 10-year yield now sits 1.76% or 0.41% higher than its December low.

The ripple effect of this rise in Treasury yields has been the rise in higher quality preferred yields. The median yield at worst in the banking sector, for example, has come close to 4%. This makes taking low coupon/duration exposure a bit more acceptable in today’s environment.

Systematic Income - Median Bank Preference Income

Systematic income

The risk of rising rates is the one that continues to weigh on investors. However, higher rates are far from the only risk. A number of macroeconomic indicators already suggest that we are entering the mid-cycle period where the economy is more likely to slip back into a recession. Higher quality longer duration preferred stocks offer an attractive allocation for this scenario as they may be supported by the typical pattern of lower rates in recessionary environments and their higher quality (i.e. credit ratings superior quality) means they can withstand a macroeconomic downturn.

A few stocks worth highlighting in the space are premium and cross-preferred stocks such as Capital One 4.375% Series L (COF.PL), JPM 4.2% Series MM at 4.4% yield, (JPM.PM) at a yield of 4.26% and Wells-Fargo 7.5% Series L (WFC.PL) at a yield of 5.1%.

Market themes

There was a quick exchange about Amtrust’s service chat preferences this week. These preferred shares were delisted by the issuer when the company was taken private with the comment that it was too cumbersome to maintain required regulatory reports. The company also recently accepted a $10 million civil penalty from the SEC over its loss reserve estimates. The privileged ones cannot be combined and yield around 10%.

Investors are basically worried that the company will suspend dividends and drop them. While this seems unlikely for a financial issuer, preferred shares are already trading around 25% below liquidation preference, so the market clearly thinks the risk is not negligible. Admittedly, part of the decline is likely due to the SEC’s No Pink Info rule which may make it difficult to trade them, forcing many holders to dump stocks.

To partially hedge against the risk of suspension of dividends, it may be advantageous for investors to limit holdings of issuers that are 1) private, 2) traded over-the-counter / No Pink Info, 3) non-cumulative and 4) emit rarely, if at all. The reputational/operational risk associated with the discontinuation of dividends is less of a concern for these issuers than for those that do not meet these criteria.

A good example here is the mREIT preference sector. Issuers in the sector are very unlikely to delete their preferred shares, as they are relatively frequent and sophisticated issuers, so they need constant access to funding markets, especially $25 preferred shares. . They are also cumulative issuers, meaning they must continue to accrue the dividend even if suspended, creating an incentive to continue paying it or reinstate it quickly.

Market Commentary

The CLO Equity CEF Oxford Lane Capital (OXLC) issues a new rating. Compared to Eagle Point Credit Co (ECC), OXLC has very little unsecured debt in its capital structure. And that is precisely what has made something like OXLCL very attractive in the industry.

To give a hunch here – the breakeven recovery rate of the OXLC 6.75% 2031 (OXLCL) note is around 9% while the breakeven recovery rate of the ECC (ECCW, ECCX , ECCY) is 20%. This means that OXLC assets can lose 91% of their value and OXLCL will always be whole, while ECC assets can only lose 80% of their value before the notes are written down.

This better margin of safety for OXLC notes will get a bit worse as the break-even point recovers to 15%, so OXLC notes will still have a more attractive credit profile compared to ECC.

Here’s what the CLO Equity ticket population looks like at the moment. There are two notes that are currently callable (ECCX, ECCY) and two that are callable in the future (ECCW, OXLCL).

Equity Notes Systematic Income Sector Median

Systematic Income Baby Bond Tool

The new OXLC (OXLCZ) note will have a coupon of 5% and a January 2027 maturity. %YTW. In this context, OXLCZ will look much more attractive, offering not only a 5% higher yield (at “par”) but also a significantly shorter maturity.

There are also two ECC notes pinned at par with maturities 2028 and 2027 (ECCX, ECCY) which trade at negative YTW (i.e. a small loss if redeemed immediately) but can sometimes get closer to negative YTW. ‘a flat YTW and YTM of 6.5% and which can also offer attractive catches.

Public Storage came out with a new Investment Grade Preference (PASDV) at a coupon of 4.1%, trading at a yield of 4.15%. PASDV is currently trading at the highest yield of the suite, with most of PSA’s favorite stocks posting yields well below 4%.

Overall, a good quality stock at 4.1% isn’t too bad. Its low coupon means that its duration will be high (the smaller the coupon, the lower the price must fall for the yield to increase by a fixed amount to match a rise in Treasury yields). In a previous article, we looked at the behavior of stocks with different coupons during changes in Treasury bond yields. In short, low coupon preferred stocks will tend to be more volatile because their prices need to change more to generate the same change in yield.

In terms of our position in the sector, we continue to run our lower beta payroll focusing on shorter dated, par-pinned and niche stocks. The recent move in yields means that we have a more favorable view of duration risk taking, however, we would first wait for Treasury yields to consolidate before adding duration exposure.