Widening Discounts In Preferred Stocks: An Opportunity To Buy PFF?

Aug.24.11 | About: iShares U.S. (PFF)
Early in August, during the sell off in global markets following the U.S. rating downgrade, preferred shares got hit pretty hard. This volatility seemed unexpected by some investors as they assumed that preferreds were just a capital structure play - claims on preferred equity are between debt and common equity, so investors often expect the risk/return profile of preferreds to line up somewhere between common equity and high yield (as the lowest claim debt). However, there are significant differences within broad indices, from both a sector and issuer exposure, that contribute to large performance differences.
Consider this: The S&P U.S. Preferred Stock Index is heavily weighted in financials (+80%), while the exposure to financials in the S&P 500 is under 15%. In addition, banks issuing preferred securities tend to be investment grade and do not issue much high yield debt (financials exposure in the BarCap High Yield Index is 11%). Given these differences in exposure, investors should not expect the iShares S&P U.S. Preferred Stock Index Fund (NYSEARCA:PFF) to perform similarly to either high yield bonds or broad equity indexes.
Although markets have recovered some of their recent losses, I found myself looking deeper into what has been driving the price of PFF. Comparing the market price of the fund holdings to their par values provided a clue – many of the securities were trading at discounts to par, some significantly so. This was in contrast to even very recently when the fund was at an aggregate premium to par, which got me thinking: does this provide an opportunity for investors as it did in 2009?
Recall in early 2009 when there was discussion of all of the U.S. banks being nationalized. Investors were scared, and due to the ambiguity of how preferreds investors would be treated should a nationalization occur, the securities began trading at a discount to par - a BIG discount - 49%.
So here we are today. The markets are like a wild roller coaster day after day and the performance of PFF reflects similar (but not exact) concerns of increased risk in the global financial sector. Compare the following fluctuations in premiums and discounts for the underlying securities in PFF:
Weighted Avg. Premium/ (Discount) to Par
Current (8/18/11)
Recent (7/26/11)
Extreme (2/25/09)
Click to enlarge
To dig deeper into the sources of the current discounts, we grouped the securities in PFF by different characteristics and looked at their weighted contribution to the overall fund’s discount. The group we found with the largest discount is fixed rate securities, which account for about 85% of the fund and have a weighted discount to par of 3.6%. Grouping a different way, the total weighted discount attributable to European financials in the fund is 2.5% (see table below). A couple of RBS securities skew this higher as they have deferred their dividend payments and are trading at deep discounts to par - taking this into account and excluding RBS, the discount from European financials is 1.8%. Finally, looking only at the Trust Preferred Securities (TruPS), which may be called at par over the next few years due to regulatory changes, the weighted average discount of TruPS is just over 2%1.
Given that European financials have dominated the news lately, I dug in deeper on the discounts to par for securities associated with individual European issuers:
Weight In PFF
# of Securities
Weighted Discount to Par (bps)
Total European Issuers
Click to enlarge
*As noted above, the RBS issues have deferred dividend payments
While the securities of these European issuers represent less than a quarter of the portfolio, they are contributing nearly half of the discount to par.
So I was left pondering these “what ifs” ...
If the risks to the global banking system are overblown, PFF could provide the opportunity for both price appreciation (if preferred equities move toward par) and additional income.
If regulatory landscape changes and TruPS are called industry-wide, the weighted discount to par of over 2% could be attractive.
Or if things for the global economy just get worse from here ... well then now is not the time to jump in. But these discounts are probably worth watching as they might get larger and present opportunities down the road.
1. These discounts are not mutually exclusive. For example, the discount in a fixed rate TruPS issues by a European financial company would be counted in all three groups.
Sources: BlackRock, Barclays Capital. All data as of 8/18/11 unless noted. Holdings are subject to change. Past performance does not guarantee future results.
Solomon Stewart contributed to this blog.

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