AGNC: Advantaged Trading In Fixed-To-Floating Rate Preferred

Back in the spring, when it became obvious that the Fed was very serious about waging an interest rate hiking campaign designed to break the pace of inflation, we got curious about what would happen to fixed-to-floating rate preferred shares as their conversion dates approached. Dane Bowler wrote about anomalous pricing he saw in fixed-to-floating preferreds and the opportunity that was evolving. On August 30th, I alerted readers to Annaly Capital’s preferred series F (NLY.PF) shares’ fast-approaching conversion date, but I could only speculate on what might happen. Yesterday, we may have gotten a glimpse of what the action could be.

The morning of August 7th was pretty ho-hum until I spotted AGNC Investment Corp. Preferred C (AGNCN) was trading above par, up almost +3% on the day. When I saw that trading volume was already a multiple of average daily volume, it felt like something must be up.

I checked all my sources but couldn’t find anything that would explain what was going on.

We bought shares of AGNCN back in the spring because they had fallen to a 10% discount to par, and they would become callable or convert on 10/15/22. We saw this as a situation in which we could book a high 7% yield that would be called for a premium to cost or convert to a potentially higher dividend yield.

At $325MM outstanding, AGNCN is significantly larger than most mREIT preferred issues. This is important in that it provides more liquidity than many fixed income investments and can facilitate better trading.

While I couldn’t verify what was causing the shares to jump, I could see that one of our expected outcomes was at hand; we could sell at par and pocket the gain. Selling at par was an easy choice when we saw that AGNC Investment Corp.’s Preferred series E (NASDAQ:AGNCO) was available in the low $22 range and posed the opportunity to repeat our AGNCN result.

In buying the AGNCO at $22.20, we improved the dividend yield we had from the AGNCN proceeds and returned to a discount to par position. While AGNCN and AGNCO are not truly pari passu issues, they are similar enough to call the gains from the arbitrage trade significantly advantaged:

• Capture AGNCN par value on sale and obtain a 10%+ discount in AGNCO purchase.
• Improve AGNCN’s carrying yield of 7.0% to 7.32% on AGNCO purchase, a 32bp increase, locked in until call/conversion on 10/15/2024.
• Reestablish 12.6% capital appreciation potential if AGNCO is called in two years.

Markets Anticipated The News

We only had to wait an hour after market’s close to understand what spurred all the activity. At 5:30 EDT, AGNC Investment issued a press release announcing the offering of 6,000,000 depositary shares of a new 7.75% Series G Fixed-Rate Reset Cumulative Redeemable Preferred Stock (AGNCL). The $150,000,000 gross proceeds can be used for any number of business/investment purposes, including “redemption in whole or in part of AGNC’s currently outstanding 7.000% Series Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock, AGNCN.

The new issue’s 7.75% coupon looks pretty pricey relative to the 7.00% AGNCN, but that is a fast fleeting spread comparison. If on October 15 AGNCN converts to floating rate at today’s 3 Month USD LIBOR of 3.24%, the coupon jumps to 8.351% (3MO LIBOR + 511.1bp). AGNC Investment not only saves money with the new issues, AGNCL locks in those savings and contains costs for at least five years until the new issue’s rate resets. This timely address brings relief not only to AGNC investors but to other mREITs facing similar fixed-to-floating timelines. The market now has an example of what refinancing options are available today.

Opportunity Ebbs And Flows, But You Must Be Present To See It

Since the onset of the rising interest rate cycle earlier this year, preferred shares have fallen from above par to discounts of as much as 25%. AGNCO shares have traded up as much as 3% today, indicating that some market watchers perceive an attractive mispricing discount. By some measures, AGNCM and AGNCP might be even more opportunistic as well as the dozens of other preferred series awaiting fixed-to-floating conversion.

While you watch coupons and calendars and the Fed, our inefficient markets may present many new opportunities. Put these issues on your radar, and you might find profit.

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