I want to discuss a few specific preferred shares. Many income investors are looking to the preferred shares of mREITs as treasury yields and high credit quality yields are hitting exceptionally low levels. Yields on junk bonds are also fairly weak when accounting for the income problems those funds may have due to defaults. Specifically, if they are holding bonds on companies that are mining for natural resources or drilling for oil, there is a substantial risk of default. As a result, investors can see the preferred shares of mREITs as a potentially interesting place to get a better yield with a lower probability of a cut in the distribution (absent a call). Since Annaly Capital Management (NYSE:NLY) is the largest of the mREITs, it also attracts more attention. Recently Annaly Capital Management used their bulk to acquire Hatteras Financial Corp. (NYSE:HTS) in a substantial merger.
Annaly Preferred Shares
Annaly has three different classes of preferred shares. They are the series A, series C, and series D. For this article I will simply refer to them as NLY-A, NLY-C, and NLY-D respectively. These are the tickers an investor can write into Google Finance to find the preferred shares, but many brokerages may use different symbols. When it comes to preferred shares, there are often several different names for the same security. However, they will all tend to have both the common ticker and the preferred series letter.
When Annaly Capital Management absorbs HTS, they will also take on the common shares. The share price of HTS suggests that investors believe there is about a 100% chance of the deal being consummated, so I'm willing to believe that the probability is extremely high.
Hatteras Preferred Shares
For HTS there is only one series of preferred stock, the A series. Those shares will be referred to as HTS-A.
The Table of Data
I put together some charts I use to watch preferred shares for investing opportunities. I pulled out the relevant data for these stocks twice. The first time was on April 13th; the acquisition was announced on April 11th. The April 13th data is shown below:
The only shares trading at a premium to call value are NLY-A. In exchange for investors taking on the risk the shares are trading at a higher current yield than the C series or D series. As recently as early March, that was not the case. When I covered preferred shares in early March, the A series had a weaker yield than the C series or D series. Ironically, I've seen this happen quite a few times. As a result, I suggest to investors that the C series and D series are significantly more attractive than the A series when they have a higher current yield.
I pulled the data again on April 19th during the trading day:
Relative to the prices a couple days after the merger was announced, we have seen the NLY-C and NLY-D shares outperform. NLY-A was at a fairly similar price again. HTS-A was climbing, but it wasn't climbing as fast as NLY-C or NLY-D. Since HTS-A should become very similar to the C and D series, the relative pricing differences appears to be a mistake by the market.
I'm not a huge fan of the current prices on the common stock of mREITs, but I do see some potential opportunities in the preferred shares. In this case I see HTS-A as the clear winner for investors that want to allocate new capital to buying preferred shares in NLY. The shares of HTS just went ex-dividend, so the accrual for them should be smaller than for NLY. However, the difference in date of payment is smaller. NLY-C has their first quarter dividend scheduled for April 1st and HTS-A has their first quarter dividend scheduled for April 15th. As a reminder, those are dividend payment dates. Those dates are not ex-dividend dates.
HTS-A or NLY-C
Aside from the difference in ex-dividend dates and pay dates, the HTS-A and NLY-C shares are very similarly priced. While these issues may have more liquidity than the preferred shares of some smaller mREITs, it isn't likely to be large enough to allow a significant long/short trade to occur. Due to the difficulty of immediately forcing the prices to converge, it should be possible for this opportunity to extend for at least a short while. Investors buying HTS-A at $24.33 are essentially getting an equivalent security to NLY-C while saving $.74 based on NLY-C's last price of $25.07.
Due to the accrual of dividends, the fair value of the discount might be smaller by about $.15 or so. If we assume that both mREITs begin accruing the dividend at the start of the quarter, then there would be no difference in accrual. If we assumed accrual from the ex-dividend date, then there would be about a one month advantage for NLY-C. In analyzing previous calls, I have not found perfect consistency in the way different REITs handle this.
I grabbed price charts on Wednesday, April 13th when I first began reviewing this opportunity. I find these price charts to be more useful than current price charts because I want to demonstrate the changes immediately following the announcement. If I zoomed out far enough on a current chart to include April 11th, it would lose too much of the detail.
The price charts through the middle of the day or so on Wednesday April 13th are shown below:
Notice that since Friday's close (referring to Friday April 8th), which was before the announcement, NLY-C is up 1.43% while HTS-A is up 4.22%. The numbers are visible in the charts, but the graphs are misleading because they don't show the closing price from Friday.
I expect HTS-A to outperform NLY-C over the next 6 to 9 months since they will pay the same coupon and will become preferred equity in the same REIT with similar dates of expiration. This is by far the most investable option among the securities discussed here because the market already adjusted for changes in the common stock.
The most material difference between HTS-A and NLY-C is the fact that this merger has not been completed, though common share prices suggest strong belief that it will be. The second factor worth mentioning is that HTS-A enjoys a slightly longer protection from calls. For most mREIT preferred shares this is not a material consideration since they trade below par value. HTS-A trades below par value, but as of my writing on April 19th, NLY-C was trading above par value.
HTS-A or NLY-D
The other option for investors is to compare HTS-A to NLY-D. The coupon rates are not the same, but the call date is almost identical. If investors wish to use this as the comparison, they can see a slightly lower price where they save about $.45. Again, the discount might shrink by $.15 or so depending on the accrual policies of the mREITs.
However, this would still be a slightly lower price that would produce an annual $1.91 in income as opposed to paying slightly more for $1.88 in annual income. Again, I believe HTS-A is the clear winner.
Could you deal with saving $.30 to $.45 up front on a per share basis and then accepting $.03 per share in additional income each year?
HTS-A or NLY-A
I believe this is the weakest comparison to make because there are several differences since NLY-A is past the call date and trading above par value. However, it is worth noting that even in this case the current yield would favor HTS-A. The investor would be able to significantly reduce the call risk by buying below par value and having over a year of call protection and they would still get a stronger yield. The cash interest per year on a single share is lower, but on a fixed dollar amount invested the yield on HTS-A is still about .09% stronger.
Annaly Capital Management Benefits Slightly Through HTS-A
Given that the HTS preferred shares are offering a better deal than investing in Annaly Capital Management's preferred shares, it might seem like the HTS preferred shares are a bad acquisition.
If Annaly Capital Management wanted to issue preferred shares now, I believe they would get somewhere in the ball park of $24.50 after the underwriting discount on shares with an original coupon rate of 7.63%. Annaly Capital Management could call their A series and do that, but it would only save about $.06 per year. Paying $25 on the A series and then getting $24.50 would leave a deficit of about $.50 which would take around 8 years (based on a rounded $.06 in difference) to save from lower dividend payments. Incorporate some other administrative costs into issuing the call and the payback period could be extended materially farther. As a result, it is not quite worth calling the NLY-A series unless NLY wants to decrease their preferred shares outstanding. Since NLY is still willing to leave the 7.88% NLY-A shares outstanding, it wouldn't make sense for them to have a negative view of assuming the 7.63% shares. Further, in the acquisition announcement NLY indicated that they intended to assume the shares of HTS-A.
Investors that want to own preferred shares from Annaly Capital Management would be making a very reasonable choice to buy shares of HTS-A instead when the yield is materially better. I doubt there will be a difference in accrued dividends any greater than $.15, and it is possible that no difference will be present. The timing of cash payments is different by about two weeks, but the timing issue seems small if investors can squeeze out another .20% to .25% in annual yield on a position they intend to hold for several years.
I was contemplating holding these and selling as soon as the price converged, but I wanted a slightly larger spread to protect me from the potential for NLY's preferred shares to decline if the market weakens again. After April 13th the difference wasn't quite large enough. Since then the difference increased but prices also moved higher which offsets some of the advantages I would see in this as a trading position. For the long term buy and hold investor, I think HTS-A is the preferred share that makes the most sense here.
Preferred shares should only be traded with "limit" orders. They suffer from poor liquidity and market orders may result in terrible execution prices.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in HTS-A over the next 72 hours.
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: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.