Arbitrage Opportunity In Wells Fargo & Co. Preferred Stock

| About: Wells Fargo (WFC)

Summary

Wells Fargo Preferred Stock WFC-W is trading below comparatively worse preferred stocks.

The apparent mispricing offers a statistical arbitrage.

Although the rewards are not huge, I trade my edge without reservations.

April 2016 has been a tough month for many traders, myself included. I relish volatility as it provides opportunities, but lately the complacent grind in the markets has meant opportunities are few and far between. However, the re-balancing of PFF, the Preferred Stock ETF last Friday provided some irrational moves and these have led to some decent trades.

When the PFF re-balances each quarter, its managers buy and sell stocks based on pre-determined rules. These often defy any logic and can be down to something as basic as a certain preferred stock hasn't traded enough volume in the period. So when you see a stock selling off heavily into the close for no apparent reason, more often than not it will be due to unmerited selling by PFF and normal order will be restored in time.

Wells Fargo and Co. (WFC) issued Preferred Stock WFC-W (Wells Fargo & Co., 5.70% Dep Shares Non-Cumul Class A Preferred Stock Series W) is one of these stocks. The chart below clearly shows the heavy volume and increased volatility in the last two sessions.

Click to enlarge

source: barchart

Most of Friday's move and volume came in the last 15 minutes of the day. The selling continued yesterday, albeit on less volume. To the uninitiated it may seem like there is a problem with WFC. But if this is the case then all their preferred stocks should be declining. The chart below shows a different story -

Click to enlarge

WFC-O has experienced average volume and has actually closed Friday and Monday slightly higher. WFC-P and WFC-N show similar characteristics. There is no heavy sell-off in the WFC preferreds.

Below is a side by side comparison of the vital statistics of WFC-W and others in the same family. If the sell-off is justified by something fundamental relating to yield or call date it should be evident below:

Click to enlarge

source: author's database

Far from being a lemon in the family, WFC-W actually has the best coupon. And most importantly, since all 4 stocks are trading above par, WFC_W has a better yield to worst if it is called in 2021. Yield to call (or worst) is 5.22%, compared to WFC-N with 3.18%. So why is WFC_W priced at $25.52, 17 cents below WFC-N at $25.69?! Well we already know that the PFF re-balancing has something to do with it, but who really cares? Sometimes the market gets it wrong and instead of questioning and guessing the underlying reasons, I prefer to profit. The prices are not statistically justified and this presents us with an arbitrage.

How I trade it

I was prepared for the PFF re-balancing and had limit buy orders for WFC_W below $25.80, which were executed at the closing print at 25.71. I averaged down yesterday and will do so again today if I have the chance. I also shorted WFC-O and WFC-N, but my overall position is naked long and will hedge further if needed.

Risks

It is possible PFF are not done selling and they will continue to do so for a sustained period of time. However this only widens the arbitrage and will allow me to lower my average. I will have no sleepless nights owning a BBB rated WFC preferred stock that I know for a fact is undervalued. Market imbalances are nearly always reversed.

If there is a broad market sell-off or a specific problem with WFC then the profit from my short positions will cover my losses in WFC-W.

Conclusion

Whenever PFF re-balances it creates opportunities. These are sometimes quite small so trades have to be quite large to make a decent profit. It is therefore essential to have an arbitrage. I will sleep well tonight with my large holdings of WFC preferred stocks.

Further note: WFC-W is the better stock to own compared to WFC-O, WFC-N and WFC-P. This is a mathematical fact not a personal opinion. WFC-L is another one I like, but it has rallied already and is a $1000 par value which makes it hard to trade for the retail investors.

Disclosure: I am/we are long WFC-W.

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 WFC-O, WFC-N