Why It’s A Stock-Pickers Market In Preferreds

Broadly speaking, investors have three ways to invest in preferred stocks: open-end funds like ETFs and mutual funds, closed-end funds and individual stocks. In this article, we take a look at the income generation of these various products in the current environment of tight CEF discounts, low yields and a flat yield curve. We think investors can find better value away from CEFs and, particularly, in individual preferred stocks. Currently, we see value in the mortgage REIT preferred space with attractive valuations in AGNCN, CIM.PC and NLY.PG.

A Platter Of Preferred Products

In the chart below, we summarize the historic yields of various preferred stock investment products over the last three years. We plot median trailing twelve-month yields for CEFs, ETFs and mutual funds. In addition, we also plot strip yields of $25-par preferred stocks from our ~600 preferred stock database. More specifically, we plot 0.5 and 0.75 quantile yields. The 0.5 quantile yield refers to the yield in the middle of the preferred stock universe, also called the median. The 0.75 yield corresponds to the yield which is greater than 75% of all strip yields on a given date. In other words, about a quarter of the preferred stock population have strip yields above and three quarters below this figure.

Source: ADS Analytics LLC, Tiingo

The chart shows a number of interesting things. First, we see that the average CEF yield has fallen quite substantially, while other yields have remained more resilient. Secondly, while the CEF yield has typically remained the highest yield among other alternatives, it has drifted well below the 0.75 quantile yield and closer to the 0.5 quantile, meaning that the CEF yield is a lot closer to the median 25-par preferred stock strip yield than at any time over the last five years.

And while the 0.75 preferred stock quantile now offers a significantly higher yield than the average CEF, its historical volatility has also been significantly lower than that of the average CEF. This suggests that not only is it possible to find higher-income producing securities in the individual 25-par preferred stock market, but that the value of those securities should hold up better than that of the CEFs.

Source: ADS Analytics LLC, Tiingo

Why has the average CEF yield fallen so far off its perch?

CEF yields have taken a beating for a number of reasons.

First, overall fixed-income yields have fallen, which means that CEF fees as a ratio of underlying asset yields have risen. So, currently, preferred CEFs are taking increasingly large shares of their underlying earnings in the form of management fees.

Secondly, the yield curve has flattened and inverted in parts. This means that the cost of leverage has risen relative to the yields available in the fixed-income market. Although LIBOR rates have fallen as the Fed has pivoted in a dovish direction, yields across the rest of the curve have fallen as well. The chart below shows that the 3-Month LIBOR / 5Y Treasury Yield curve is inverted and close to its post-crisis lows. This suggests that it is less attractive now to generate yield using leverage than at any time over the previous decade.

Source: ADS Analytics LLC, Tiingo

Thirdly, the average preferred CEF discount has narrowed and is currently trading at a premium, not far from its record high since the start of the century. The tighter the discount / the higher the premium, the lower the yield of the fund – all else equal.

Source: Systematic Income CEF Tool

A Case Study – JPS

In order to illustrate what is going on with CEF yields, we disaggregate the yield of the largest preferred CEF – the Nuveen Preferred & Income Securities Fund (JPS).

The chart starts off with what we call portfolio yield, which is just total fund net income divided by total assets, and through the addition of leverage, fees and discount results in price yield, which is the yield that investors actually earn on their cash on the fund’s underlying assets.

Source: Systematic Income CEF Tool

An ideal CEF investing environment has two key features:

  • CEF discounts are sufficiently wide to compensate for high CEF management fees.
  • Leverage costs are sufficiently low to provide a significant boost to CEF net investment income.

The chart above suggests that neither of these two criteria is fulfilled. Firstly, the additional yield provided by the discount is minimal (this is a function of both the tight CEF discounts as well as low underlying yields). And secondly, the total fund expenses of 2.95% largely wipes out the 3.44% of additional income provided by leverage. This means that investors are left earning just an additional 0.5% (or less than 10% of the portfolio yield), while taking on significant additional price risk which comes not only from the CEF leverage but also from the tight CEF discounts.

Are there arguments for sticking with preferred CEFs? Possibly – there are two important reasons why investors may want to keep a CEF allocation. First, active management of preferred securities has historically done better than passive management. We show this in the chart below where we compare CEF and mutual fund total NAV returns (both of which tend to be active products) against ETF returns (which tend to be passive products).

Source: ADS Analytics LLC, Tiingo

While leverage has also flattered CEF returns, mutual funds are typically unleveraged and have also done significantly better than ETFs. In this case, to take advantage of active management, we would prefer mutual funds over CEFs, as they have seen significantly lower historical drawdowns than CEFs.

Source: ADS Analytics LLC, Tiingo

The second reason why investors may want to keep some allocation to CEFs is if they believe interest rates will continue falling, which will boost returns through the CEF use of leverage. In our work, we try not to forecast the path of asset prices, choosing to follow asset valuations instead. All of the key interest rate metrics we follow, such as real rates, inflation risk premium and term premium, suggest that the interest rates are at unattractive levels. So, strictly on this basis, we would tilt away from products that take a leveraged position on interest rates.

Source: ADS Analytics LLC, Tiingo

Finally, there are allocation differences between CEFs and the universe of preferred stocks available to retail investors. For example, CEFs have access to European securities such as contingent convertibles, as well as the institutional 1000-par stocks which tend to be less liquid than their 25-par counterparts. We don’t have a good answer here, except perhaps to rotate to term CEFs such as the Nuveen Preferred & Income Term Fund (JPI) or the Nuveen Preferred and Income 2022 Term Fund (JPT) that should provide a higher risk-adjusted return if you want to keep an exposure to these pockets of the market.

A DIY Approach

So, while there are reasons to keep a CEF allocation, we think these reasons are simply not as compelling as they have been historically. So, where does this leave investors who wish to keep an allocation to preferred stocks?

For those investors who wish to keep invested in fund products, we would recommend switching to mutual funds, term CEFs or the active First Trust Preferred Securities and Income ETF (FPE). A potentially more compelling option, however, is to go with a DIY solution – by picking individual preferred stocks.

As many preferred stock investors know, one thing to watch out for is the yield to call, which for some stocks can be well below the current or strip yield and even negative. A negative yield to call does not necessarily mean that the stock is a bad investment – it just means that investors need to evaluate the likelihood of the stock being called away.

Source: ADS Analytics LLC, Tiingo

At Systematic Income, we favor a two-pronged approach in our preferred stock selection and screens, tilting towards stocks with either an attractive YTW or those stocks with attractive strip yields that are not trading at YTW significantly below zero. This latter criterion ensures an attractively asymmetric payoff – if the stock is called as soon as possible, the investor would not suffer a significant loss, but would continue to benefit from an attractive coupon in the absence of a call.

Currently, financial sector and CEF stocks appear less attractive on a yield basis, with mREITs and energy trading at the wider end. This is arguably justified given the higher mortgage convexity impacting book values due to lower rates and increased refinancings, while the energy sector has been buffeted by investor pessimism and oil price volatility.

Source: ADS Analytics LLC, Tiingo

As a starting point, we begin with the following set of stocks, screened using the following criteria:

  • YTW > 5.5%: Stocks with yield-to-worst above 5.5%
  • 1-Year Drawdown > -5%: For stocks that have been issued recently, this test is done on the longer-trading preferreds of the same issuer
  • Daily Volume > 20k
  • Empirical duration < 2: Selects stocks with less sensitivity to interest rates
  • YTW Sector Spread Percentile > 70%: Selects stocks trading relatively wide to their sector average yield

After this screen, the highest-yielding stock of a given issuer is chosen, regardless of when they began trading. This screen effectively chooses names that have been resilient through the end-2018 sell-off, are reasonably liquid, offer a good yield and that are trading cheap to the sector.

From among the resulting list, we like:

  • AGNC Investment Corp., 6.875% Dep Shares Ser D Fix/Float Cumul Red Preferred (AGNCM)
  • Chimera Investment Corp., 7.75% Series C Fixed/Float Cumul Redeem Preferred (CIM.PC)
  • Annaly Capital Management, 6.50% Series G Fix/Float Cumul Redeem Preferred (NLY.PG)

Source: Systematic Income Preferreds Tool

Takeaways

Among the possible preferred stock investment vehicles at the disposal of income investors, we find CEFs less attractive due to low asset yields, rich interest rate valuations, tight discounts and still-high relative leverage costs. We think investors can find better value in active ETF vehicles such as FPE, mutual funds or direct investments in preferred stocks. Currently, we see value in the mortgage REIT preferred space with attractive valuations in AGNCN, CIM.PC and NLY.PG.

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Disclosure: I am/we are long AGNCM, CIM.PC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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