My last article about the iShares S&P US Preferred Stock Index Fund (NYSEARCA:PFF) stated that I do not see any reward in buying the fund, but the fund is safe in terms of interest rate risk. The market reminded all of us that the main risk one should be considering is the credit risk. The first round of selling was in relation to the widening credit spread of Deutsche Bank (NYSE:DB) and the sell-off in the so-called CoCo bonds. The three preferred issues of DB (Deutsche Bank Contingent Capital Trust 2, 3, and 5 respectively DXB, DTK, DKT) fell more than 20% on sympathy:
The three issues altogether represent less than 3% of PFF's assets, so it is really not that big of a deal. The problem here is that in the heads of all traders, DB preferreds were like a safe haven for quite a long time. As we learned from the financial crisis, a problem in one big bank is a problem for all the banks in the world. Every trader I know started either selling or shorting all European companies' preferred stocks that trade in the US. This is a kind of "sell first, ask later" selling. Even the thought of credit risk widening is enough for everyone to get rid of those negative "yielders". You do not have any potential in big part of those preferred stocks as stated in the previous article, but you think they are safe and suddenly the market is telling you that there is also a credit risk. The lesson one should learn from this sell-off is to not invest in instruments without potential, the reward will just not happen, but the risk can always surprise you.
Why I found sell-offs like this very positive
Let's face it, honestly most of the people have no idea what they are doing on the markets (for example, public is buying because Buffet is buying?). Public is buying PFF because of the current yield and because they know preferred stock is safe, but most of them have no idea what the fund actually consists of. This kind of behavior is spread all over the market and all over our lives. The only thing that makes us learn through the years is the pain. Once you feel the pain, you do not want to feel it again. (Bundesbank (now the ECB) is all about price stability, because they felt the pain of hyper inflation). A trader or investor who gets burned in PFF will definitely read more and will improve his knowledge so much that he will end up with a positive experience after all. Learning by losing is not the most pleasant type of education, but it limits your moral hazard and makes you a better "player" in the long run.
Preferred issues to avoid:
- First thing to avoid is negative yield to worst. That is a must in fixed income investing. That is a must in every business actually. If the normal course of action makes your internal rate of return negative, run from this investment.
- Keep it simple and avoid preferred stock that has its common stock lost a big percentage of its capitalization. This is not 100% accurate, because a company's price might fall without any effect on debt and preferred stocks, but you will not miss the trade of your life by not buying a $25 preferred stock with $1 capital appreciation potential.
- Fixed to floating preferred that trades well above par. It is hard to generalize, but most of those issues are very cleverly built by the issuing companies (Do not forget most of them are smarter than you in terms of financial planning). For example, State Street Corp. 5.90% fixed to floating preferred stock was recently trading at $28.50, before the sell-off in PFF. Click to enlarge
This stock resets its coupon payment to 3-month LIBOR + 3.18% in 8 years and is callable on that same date. (A smart move by the company). This means that if it is in their benefit to call the stock, they will call it and if not, then the stock will definitely trade bellow par. This means that the 3.87% yield to call is actually the best thing that can happen to a long-term holder. A lot of people think that by buying fixed to floating issues, they buy safety from interest rate risk, but that is so wrong. If the three-month LIBOR stays static, this stock will trade at $20 like similar 4% nominal "yielders" and your yield to hold would be around 1.5% for the 8 years. This is just one of the examples in the fixed to floating preferreds. They were all valued like that which was baloney. The sell-off brought some logic to the market and people started realizing that by buying passive strategy ETFs, they are just throwing money away. Do not expect a passive buyer to do the thinking for you. You give him money, he buys. If stocks go higher, he is a big master, otherwise it is the market to blame.
What stocks to load on a sell-off
First thing is to determine what is the cause of the sell-off. In this particular case, it was credit risk related. It means, you have to load stocks that are selling just in sympathy with the rest of the market, but do not have their credit risk (credit risk sentiment) changed. You cannot make a fundamental analysis on all of the stocks that got hit, so I suggest concentrating on the common stock behavior. My example is PartnerRe Ltd. (NYSE:PRE). The stock is awaiting a buyout that is the first in my trading experience that gives so much benefit to preferred stock holders. If the deal goes through, preferred stock gets a boost in nominal yield, as well as no redemption clauses and definitely the credit risk will not be higher. If there is risk to the buyout, the common stock will be the first to respond:
It may sound too simple to a lot of people, but for me this was quite a reason to buy all the PRE preferreds on the sell-off as much as my limits allowed me.
Another class of fixed income to look at on a sell-off, are instruments with short duration (near term maturity dates, putable products, stocks with failure to redeem clauses). Those stocks sometimes get punished even more than perpetuity, which is a clear arbitrage opportunity.
Buying without knowledge and research is a disaster. Moral hazard is so high that this disaster behavior ends in nice profits as long as the public acts as a herd. What I found really strange is how people are so worried when some real logic and financial thinking comes to the markets. How can you not see a problem when you passively buy a stock with negative internal rate of return, but you see a real problem when the price of this stock falls. It seems that the pain in 2008 was not enough to change the behavior of the people, so who knows what lies ahead. And don't worry, as long as we just buy stocks instead of selling, the "Ponzi Scheme" will work.
In addition, I am adding one stock to my Arbitrage trader portfolio.
The stock is Seaspan Corporation (NYSE:SSW)-E preferred stock. I will leave the reader to determine why this might be a nice pick.
Disclosure: I am/we are long SSW-E, PRE-D.
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 short PFF as a hedge