Darren415
This article was first released to Systematic Income subscribers and free trials on Jan. 19.
In this article, we take a look at a number of low-spread floating-rate preferreds such as the U.S. Bancorp Series A (USB.PA), which are trading at yields north of 7%. We expect these securities to benefit the most from rising short-term rates in both yield terms as well as total returns. And, since many of these stocks are high-quality, they can also perform well if we do indeed enter a long-anticipated recession this year.
The key attraction of these low-spread preferreds is that they are more highly leveraged to higher short-term rates. In other words, all else equal, their yield will rise at a faster pace than the more common floating-rate preferreds (i.e., those with higher spreads over Libor). This should also translate into their prices rising at a faster pace than their counterparts in order to keep up with their faster-rising yields. Interestingly, this does not appear to be priced into shares yet.
The two key dynamics of short-term rates that are favoring these stocks at the moment are that: 1) short-term rates are still rising, though at a slower pace than in 2022 as the Fed has indicated they are not done with the hiking cycle; and 2) there is a significant lag in how short-term rates are translated into preferreds dividends due to the combination of quarterly accrual periods, the rate setting at the start of the accrual period, and the gap between the end of the accrual period and dividend payment.
What are low-spread floating-rate preferreds? They are preferreds with floating-rate coupons, typically linked to Libor plus a spread, however, their spread is on the lower side.
In short, what makes these stocks unusual is the relatively low spread over Libor of 1% or below. Most preferreds have floating-rate coupons with spreads of 3-6% over the floating-rate, e.g., SOFR + 6% or Libor + 4% etc. However, these low-spread preferreds have floating-rate coupons closer to Libor + 1% or below with some having coupons as low as Libor + 0.35%.
Finding value in lower coupon stocks seems counterintuitive – shouldn’t investors focus on higher yields, all else equal? All else equal, lower coupons and lower yields are less attractive, however all else is not equal in this case.
This is because despite their low coupons, the yields of these stocks are already at attractive levels since the prices of low-spread preferreds are lower than their more conventional counterparts.
And secondly, a low spread means the total coupon increases at a faster pace than the coupon of a typical Libor + 3% preferred. A move from Libor of 4% to 5% increases the coupon of a Libor + 3% preferred by 14% (i.e. from 7% to 8%) but by 20% for a Libor + 1% preferred (i.e. from 5% to 6%). This means that the yield of the Libor + 1% preferred will increase by a larger amount for the same increase in Libor. This also implies that the price of the Libor + 1% preferred should rise faster, in response to its more rapidly rising yield.
Let’s take a look at the U.S. Bancorp Series A (USB.PA) as a case study. The stock has a stripped yield of around 6.6% which is a function of its stripped price of around $787 (it has an unusual $1000 liquidation preference) and latest declared dividend of $13.031. The stock has a coupon of 3-month Libor + 1.02%. It has a 3.5% floor as well but that feature is not relevant at the current Libor level (though very handy if Libor collapses).
USB.PA accrues quarterly dividends with periods starting in 15-Jan, 15-Apr and so on. This latest dividend started accruing on 15-Oct when Libor was around 4.193%. For example, the $13.031 dividend was calculated as (4.193% + 1.02%) x about 0.25 of the year x $1000 liquidation amount.
The next coupon will start to accrue on 15-Jan and it will be set at Libor of 4.792%. The resulting coupon in April will be around 5.812% (4.792% + 1.02%) versus 5.213% for the previous quarterly period (4.193% + 1.02%) – a rise of 11%. This new dividend equates to a yield of 7.38% – very attractive for an investment-grade security.
What’s interesting is that USB.PA is already the highest-yielding US Bancorp preferred and its yield will rise faster than all USB preferreds save for USB.PH, which is also a low-spread preferred, though trading at a lower yield. The upcoming rise in the stock’s yield will put USB.PA even further above the yield of the other preferreds as well as versus the broader sector, likely resulting in a price rise as well. It’s possible that some investors are put off by the $1000 liquidation preference (as they may be by WFC.PL or BAC.PL), which is causing a kind of bifurcated market with the stock seeing less demand than if it were a $25-liquidation preference preferred.
In addition to USB.PA we also like the following low-spread preferreds:
These preferreds have yields of 6.8-6.9% at today’s Libor of 4.8%. This is in the context of an average yield of 5.9% for bank preferreds and a yield of about 6.5% for the broader exchange-traded preferreds market.
Takeaways
Low-spread preferreds are very attractive at the present moment due to their dividends being more highly leveraged to rising short-term rates. Because the Fed is not yet finished with the hikes and because short-term rates take time to pass through to preferreds dividends, these stocks should enjoy significant yield rises relative to more traditional, i.e., higher-spread floating-rate preferreds and certainly relative to fixed-rate preferreds.
These preferreds have a number of other advantages. Their low prices (due to their low-spread over Libor) means there is much less downside than the average preferred in a catastrophic scenario and a ton of potential upside in case of redemption. These preferreds also tend to boast coupon floors which would keep their dividends above the level of the average floating-rate preferred in case Libor moves back towards a zero-ish level over the medium term.
The key risk to these preferreds is that their high dividend beta to the upside of short-term rates is similarly high to the downside. Specifically, if the Fed decides to start cutting the policy rate in short order, the dividend of these preferreds will fall more quickly, resulting in underperformance to boot. This scenario is not our base case as we expect the Fed to keep hiking at a slow pace (i.e., in 25bp increments) this year and then to pause in order to allow the hikes to show up in economic performance.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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