FRAPs: The Preferred Play For Preferred Stocks

| About: iShares U.S. (PFF)

Summary: First in a series of articles regarding various areas of the preferred market. The goal is to provide a framework which identifies short term arbitrage opportunities for aggressive traders and the best preferreds with hedges for long-only investors. This article will focus on a relative new entrant to the preferred market - the fixed rate / adjustable preferreds (FRAPs). They provide a free option on higher rates as well as positive carry versus non FRAPs.

Fixed Floater Background: As the name implies, the fixed floater gives a high fixed coupon before it turns into a LIBOR plus lower yielding coupon at a preset call date. This construct addresses the two main cornerstones of today's preferred stock investing: the need for yield and the concern for higher rates. The taper scare that hit the bond market this year exposed the risk of long duration fixed preferred stocks, and increased the need for a floating feature.

As taper worries pushed up the ten year yield (dotted white line), the long maturity profile of a randomly generated fixed preferred index (red line) vastly underperformed JNK and HYG. Even though preferred stocks fell out of favor, banks still had to issue them. This was mainly due to the Dodd-Frank Act and Basel III. On the one hand, the Dodd-Frank Act is reducing the supply of preferreds as banks are phasing out their trust preferreds. On the other hand, Basel III requires banks to issue more Tier I capital or otherwise reduce assets. Due to these circumstances only FRAPs with investor friendly terms were able to be floated into an unfriendly market. $6.5bn worth of FRAPs has been issued this year versus $11.1bn for all prior FRAPs. It's a small part of the overall US preferred market, which is estimated at over $200bn. Below is a table of the 2013 issuances:

The recent issuances of FRAPs have democratized the preferred market. Prior to this year institutional traders were getting better terms for preferreds on the OTC market than retail on the exchanges. For example, Citibank came out with a fixed preferred at the same time it came out with an OTC FRAP for institutions. The latter has outperformed the former by 9%:

If these FRAPs were designed with the same terms favored by institutional clients, it stands to reason that they are superior to the older preferreds sold to retail clientele. That should enable arbitrage trades or at the very least offer better preferreds to swap into. Following are the new FRAPs compared to older preferreds from the same issuers:

Three important notes regarding this table:

  1. In order to compare QDI eligible preferreds versus ineligible preferreds there is a taxable equivalent column. The current yield gets adjusted with the difference between the qualified dividend income tax of 15% and a sample regular income tax of 28%. For corporate investors the QDI ones are DRD eligible (for only a 10.5% effective corporate tax rate), making the advantage more pronounced.
  2. The Option Adjusted Spread (NYSE:OAS) measures the spread over the appropriate risk free rate and adjusts for the call option. In the above table, since we are comparing preferreds of similar issuers, the higher the OAS the better.
  3. Likewise, the floating feature also has to be accounted for. It's a great advantage that is often overlooked in the current low short term rate environment. When rates rise, it has an offensive quality, as the yield will rise. But more importantly, it has a defensive quality in that when yields keep rising, the issue will get called. Hence, the duration will shorten at a time when you want low duration. This makes it drastically better than fixed perpetual preferreds, whose duration is infinite. Depending on your outlook of the yield curve you can attach a value to it. Inflation prognosticators will find it much more valuable than deflationists. Already, the 3 month LIBOR curve is at 3% for Dec 2017, at which point the floating feature will be higher than most fixed coupons.

Looking at the above table, it is clear that the FRAPs are superior to the non-FRAPs. Not only are the OAS spreads higher, the tax equivalent yields are mostly the same or higher. In those cases, that means you are getting the floating option for free. This is an egregious mispricing that would not exist with regular goods. For example, if there are two identical cars on the same lot but one came with insurance, those cars would have different prices. Looking at the first 2 preferreds we see MS-E (a FRAP) that has an almost 1.5% higher tax equivalent yield than MSK (a non-FRAP). More importantly, it has a conversion to 3 month LIBOR + 432 bps feature. If we have an increase in inflation and LIBOR moves up, the FRAP will start trading at a high premium. The non-FRAP with its 2067 maturity will be sold off along with other long duration assets.

Trades for long only investors: Holders should switch to FRAPs in all cases above, other than AHL and ALL. If investors hold preferreds from issuers that do not have FRAPS, it will probably make sense to switch to FRAPs from other issuers. That should be done on a case by case basis, as different issuers might have different credit issues, and some fixed preferreds might be superior depending if the investor attaches a low value to the floating feature. One can use ratings and a CDS adjusted OAS to help determine this. Here is a sample of some widely held preferreds that look unattractive versus FRAPs: AEF, AEV, INZ, IND, USB-N, GSJ, DTT, NEE-C, RBS-E, BCS-C, RF-A, PNC-Q.

Trades for aggressive traders: Traders could short fixed preferreds and go long FRAPs. There is no credit risk due to the singular issuer of both the long and the short leg of the trade. Problems could arise with short locate availability but most are available for reasonable rates at Interactive Brokers. There is positive carry on most of these trades. The following five look the most interesting:

Then for those with locate difficulties, here are two good trades of FRAPs versus equivalent credit ETFs:

ZB-G (white) versus JNK (red):

WFC Q (white) versus LQD (red):

These especially make sense in light of the recent underperformance of preferreds versus other income vehicles. Furthermore, the carry is higher when using the ETFs for the short legs. JNK yields 6.2%, LQD less than 4%.

Conclusion: Tapering worries have led to exchange-issued FRAPs that offer much better terms to investors than existing fixed preferreds. Preferred investors would do well to swap into FRAPs. Aggressive traders can pair trade these two types of preferreds and still get positive carry.

Main preferreds mentioned: Morgan Stanley (NYSE:MS) - MS-E, MSK. Goldman Sachs (NYSE:GS) - GS-J, GSJ. Aegon (NYSE:AEG) - AEF, AEV. ING (NYSE:ING) - INZ, IND. Zion (NASDAQ:ZION) - ZB-G, ZB-H. PNC Bank (NYSE:PNC) - PNC-Q, PNC -P. Citibank (NYSE:C) C - C-J, C-C. US Bancorp (NYSE:USB) - USB-M, USB-O.

Disclosure: I am short PFF. 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.

Additional disclosure: I am long Goldman Sachs (GS) pref GS-J, Zion Bank (ZION) pref ZB-G, Morgan Stanley (MS) pref MS-E I am short Aegon (AEG) pref AEF, short ING (ING) prefs INZ and IND