Weekly Preferences Review: Why not just hold the highest quality preferences?
This article was first published to Systematic Income subscribers and free trials on May 16.
Welcome to another installment of our weekly Preferences Market Review, where we discuss activity in the Preferences and Baby Bonds market from both 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 second week of May.
Be sure to check out our other weekly updates covering BDC as well as CEF markets for insights across the entire revenue space.
It was another difficult week for the preferred sector. The main difference, however, was that this week’s selloff was not due to higher Treasury yields (the 10-year yield fell around 0.2%), but to higher Treasury spreads. credit.
In short, the market began to behave as if it was more concerned about a recession than inflation. The view here is that a recession is 1) quite likely given the Fed’s historically poor track record of being able to stage soft landings and 2) is a more likely, albeit painful, remedy to the current persistent inflation.
The result was that higher quality sectors like banks ended the week in the green while lower quality sectors continued to sell off. This is a theme that we highlighted in a recent article as a reasonably likely consequence and one that investors should seriously consider.
For the month, all sectors remained in the red, with energy and CEF outperforming.
Selling has been fairly consistent with the past 6 weeks, all bringing negative returns.
May delivered about the worst monthly performance so far this year, matching those of April.
A recent comment in our favorite weekly where we highlighted the preferences of agency mortgage REITs (such as DX.PC) was something to the effect of “why should I own real estate rather than a bank qualified as superior preferring to pay 6%?”.
And it’s certainly true that bank prime yields have moved north of 6%, with some higher quality issues paying well above 6%. As shown in the chart below, this level has only been exceeded for a few days over the past 5 years.
However, we remain of the view that investors should diversify across a wider range of securities. Specifically, we would like to make the following points.
First, agency MBS, which DX owns, are not “real estate” – they are mortgage-backed securities issued and guaranteed by GSEs (government-sponsored enterprises).
Second, the vast majority of bank preferences are both low-coupon and fixed-rate, so their duration is longer than that of DX.PC. Note that while the preferred average bank is down 14%, DX.PC is down 5% year-to-date.
Third, DX.PC’s stripped yield is 1% higher than the preferred typical bank and its reset yield is over 2% higher.
Fourth, although mREIT preferred stocks do not qualify, they do benefit from Rule 199A which grants a 20% rebate on REIT dividends.
Fifth, banks are the largest preferred bank sector, suggesting that many income investors are already overweight preferred banks, either directly or through preferred funds such as CEFs.
Six, qualified vs. non does not matter in a tax free account.
Seventh, mREIT preferences are cumulative while banking preferences are not. Personally, we don’t think this is a big deal for blue chip issuers because it’s not worth messing with preferred shareholders, but it could be a problem for some seedy bank issuers.
As we like to say, income-driven investing is about more than the one-dimensional axis of quality. Quality is important but it’s not everything.
Mortgage REIT Arlington Asset Investment (AAIC) had an excellent quarter. As our previous article suggested, there were some bright spots for book value. First, the company had reduced its agency allocation – a good move considering the terrible performance of the agency MBS base over the past 6 months or so.
Second, its leverage was exceptionally low for the quality of its portfolio. Third, he expanded his MSR portfolio – clearly a good move given rising rates (MSRs have negative duration) – we’ve seen how well NRZ fared with his large MSR portfolio. Fourth, the timing of its SFR (single-family residential) real estate segment was excellent given the evolution of house prices over the last year or so.
In short, book value rose 0.5% over a period when you can count book value gains in the mREIT sector on Captain Hook’s hand. This is clearly largely due to the company not paying ordinary dividends and its ongoing redemptions well below book value, but even without these factors the change in book value would have been among the best.
The fact that SFR’s portfolio is written down in book value rather than reflected in some sort of mark-to-market valuation means that the book value is in fact significantly understated.
Speaking of the SFR portfolio, the company is in negotiations to sell most of it – the buyer still has 2 weeks to do their due diligence and if the sale goes through it will be a 7% gain in book value. It seems strange that AAIC would turn around and sell its SFR portfolio so quickly, especially since it said it would then grow it again, but the idea seems to be to monetize SFR’s gains by book value, perhaps as an odd move to pull the stock price higher.
Given the round-trip costs involved, it’s probably not the best way to run an mREIT, but you can’t argue with the positive impact on book value. It also reduces portfolio risk in the process as it will take time for the company to find new properties. If they increase the portfolio to $200 million, that will be about a third of his overall portfolio.
This week, AAIC.PC took a dive (while recovering almost half of the drop in results). We don’t know what drives this. Our first thought was that someone was reassigning to AAIN, which would make sense, but AAIC.PC still fell even after the yield differential to AAIN widened again. Liquidity is low in AAIC.PC, so maybe someone was just trying to get out – we’ve seen something similar in other stocks. The upcoming liquidation proposal, if approved, could offer a decent upside from current levels. We continue to hold AAIC.PC in our high income portfolio. It trades at a yield of 9.23% (expected reset yield of 10.10% in 2024). It has equity/preferred coverage of 6x and economic leverage of just 2x.
Another mortgage REIT Granite Point Mortgage Trust (GPMT) reported earnings with book value down just 2%. This is a great result in the context of the broader mREIT market where double-digit book value declines are quite common. GPMT has a similar profile to FBRT, focusing on commercial real estate, i.e. CRE loans.
Recourse leverage for both is around 1x and preferred equity/hedging is quite high (FBRT at 6.8x and GPMT at 5.3x). (FBRT.PE) is arguably more attractive here given that its yield is 8.9% versus 8.3% for GPMT, but (GPMT.PA) is a Fix/Float with a first call date end of 2026 linked at SOFR + 5.8% with, exceptionally, a floor of 7%. This means that its yield could reach 10.2% based on short-term rate expectations in 2026 (ie around 3% in the longer term). In the worst case, GPMT.PA will return 8.1% or what it is now if short-term rates return to zero.
Position and takeaways
The two areas we are focusing on in the preferred stock and baby bond space have been the higher quality, lower coupon stocks that we have been highlighting for the past few weeks. And these have held up much better during the recent period of stable Treasury yields and rising credit spreads. A shallow recession is becoming the consensus call very quickly, given the persistence of inflation, the Fed’s growing hawkishness and its historic low success rate in engineering soft landings. These securities should outperform in this scenario of rising credit spreads and falling Treasury yields. The titles mentioned in a previous weekly still make sense to us.
The second area of interest relates to the short-term reset preferences described in a previous article. The idea here is that the market may be underestimating how far the Fed is likely to have to push rates to bring inflation down. Former New York Fed Chairman Bill Dudley is one of many commentators who see the scenario of a 4% to 5% Fed policy rate as increasingly likely. These securities will largely benefit in this scenario not only from a higher level of income but also from their resilience given their upcoming switch to a coupon linked to short rates.