This article discusses what are the best floating preferreds and in which scenarios they are superior to fixed preferreds. This is a follow up to my FRAPs article published last month.
Floating preferreds offer floating rates, usually based off of 3 Month LIBOR. Most of them have a minimum dividend rate. That floor is lower than the dividend rates of fixed preferreds, with the difference representing the price paid for the floating option at the time of issuance.
Below is a list of floating preferreds pegged to 3M LIBOR with a minimum floor:
The capital gains potential is the percentage a stock can still rise from its current price to reach its par/call price. In order to adjust for credit risk, a one percent additional yield is added to the investment grade issuers. This represents the difference between the Bloomberg Corporate BBB Index and Bloomberg Corporate BB index. The adjusted OAS is the OAS minus the CDS, so we get a spread to treasury that accounts for both the call option to the issuer as well as the credit risk of the issuer. The floor breakeven column indicates when the floating feature will pass the rate floor given the current 3 Month LIBOR curve shown below:
On a risk-adjusted basis the top six floaters to hold are: HBA F, HBA G, AEB, MET A, MS A and USB H. We can refine this first cut by using the adjusted OAS spread for an additional criterion. Then we are left with USB H and the HBAs giving the holder the best risk-adjusted returns. Holders of any of the other floaters should consider switching to these three. Of the three finalists, USB H was the most resilient during the financial crisis, as shown in this graph of USB H (white) versus an index of the other five (red):
USB H solidly outperformed by a range of $2-$6, not only during the financial crisis, but also during the European crisis of 2011. Over this 6 year period, USB H is now at the 8th percentile in terms of relative cheapness. USB H has the most defensive profile without sacrificing yield. The HBAs are a close second; HSBC USA's risk profile has altered dramatically due to the sale of its consumer lending business (created in its Household Financial acquisition several years back).
The cheapness of USB H might in part have to do with a holder unwinding their position. On September 9 there was a sale of 5mm shares, and on September 6 and October 24 there were sales of 1mm shares. These are strong headwinds for a stock averaging around 150k shares traded daily. The upside to this is that there are no large sellers remaining; the top 3 holders combined own 5 million of the 40mm outstanding shares, and one of them has started buying this year.
Floating Versus Fixed
Having ferreted out which floaters are superior, let's delve into how they may trump fixed preferreds. As a whole the floaters have underperformed the fixed preferreds. An index of floaters (white) has been underperforming their fixed perpetual counterparts (red) noticeably since the beginning of summer:
Much of the underperformance is attributable to lower coupon assets having higher duration. The taper scare this summer caused panic amongst investors that have reached for yield in high duration assets. The lower rates on these floaters caused them to be sold alongside some of the lower coupon fixed preferreds. However, the current rates on floating preferreds are lower for reasons that are advantageous in a rising yield environment. The following three characteristics may give the pure floaters an edge over fixed preferreds that is not priced into the market:
- Due to the Fed's zero interest rate policy (ZIRP) market expectations are for flat short term rates for the next two years. This has lowered the value of the floating feature, despite the fact that ZIRP is expected to end in two years and the floating feature is perpetual.
- The preferred floaters are trading at a discount to par which gives the floaters a capital appreciation potential not found in the fixed preferreds. Fixed preferreds have higher coupons than the floaters' rate floors; hence they trade at a higher price.
- The floating feature serves as insurance against higher interest rates, and will truncate the duration of floating preferreds versus their fixed counterparts.
Let's walk through an example and go through two preferreds of the same issuer: USB H versus USB O. USB O is a fixed perpetual preferred with a coupon of 5.15%. The above LIBOR curve shows when the floater will be equivalent to the fixed, which is in 2021, when LIBOR is at 4.6%. At that point the price of USB H and USB O should converge, and the $1.76 price differential will have collapsed to zero. For simplicity's sake I have USB O losing that amount to match USB H (this will happen in a higher rate scenario) and the cash flows are undiscounted as the timing of the 1.76 is uncertain. The cash flows to the holders of USB H will be similar to USB O throughout the duration. These numbers are in the last row. This indicates that at current prices and given the current LIBOR curve, investors should favor USB H. This will only improve as we go past 2021. I added other fixed coupon perpetuals and the results are even more pronounced:
However, this excludes the defensive properties of USB H. If rates rise significantly, USB H will be protected by its floating feature. USB O on the other hand is a fixed perpetual and hence one of the worst positioned of all income instruments in a rising rate scenario. The effective duration of USB O is 13.3 compared to 2.1 for USB H (source: Bloomberg). So over the next eight years you are getting similar cash flows from a short duration preferred than a high duration preferred! This defies financial logic. The additional preferreds in the matrix prove this is not an exception. In some cases holders of the floaters are even getting paid more for their better duration profile. Furthermore, the price differences will be augmented when/if higher duration assets start under-performing shorter duration assets. So that $1.76 could increase. Investors should look closely at their fixed preferreds to see if they are not holding anything that could be outperformed by a lowly floater. Especially those investors who believe they will see higher rates in the future. They might give a much higher premium to the floaters, as other corporate bonds pay 2% + more yield to compensate for going from short to long duration. Investors that felt uncomfortable during this summer's taper scare should consider what a recurrence will do. Many of the fixed preferred with a 5%-6% coupons are currently inferior to floaters, and in a taper scenario many of the 6%+ fixed preferreds will join them.