Fixed-to-floating preferred stocks are a very peculiar financial instrument. They are very much in tune with the financial world we are currently living in - the world of financial engineering. But are those securities really that different from many other conventional fixed income securities? I don't think so. It just takes a while for a person not familiar with their special features to understand how they truly work.
I actually took a stab at those preferred stocks when I wrote an article about them a couple of months back. At the time, it felt like all market participants were rushing in to buy fixed-to-floating preferred stocks in order to hedge against expectations of rising interest rates. I pointed out then that the call options embedded in almost all of these securities make them an unattractive instrument for hedging against rising interest rates and that the ultimate winner of the switch from fixed to floating is the issuer.
Now the VRP has come off the highs and is trading at 24.58.
Why would an ETF comprised of fixed-to-floating preferred stocks, which many believe provides you with an excellent protection against increasing interest rates, decline now? After Trump's election fixed income instrument providing protection against rising interest rates should be moving higher, not lower. Instead, VRP has barely reacted. Why is the ETF not moving higher?
The answer, as I wrote in my previous article, is that fixed-to-floating preferred stocks provide protection only in their names. And the reason for that lies in the embedded call option in all of these fixed-to-floating securities. In the rest of this article, I want to lay out once again how the call option impacts the behavior of fixed-to-floating preferred stocks and see whether there might be some attractive opportunities among those securities. First, let's take a look under the hood of VRP:
What immediately comes across from this table is that the fund is mostly invested in BB and BBB rated securities. Also, VRP is heavily weighted towards financials, which makes its recent decline even more strange as financials have seriously outperformed the rest of the market after Trump was elected as president of the United States.
Now, let's focus on some of the top holdings of the VRP, whose weights haven't changed much since the fund was trading close to its highs. In the table below you can find some relevant information about those issues:
Source: Author's spreadsheet
One more thing that is not visible in the data above - for all of the fixed-to-floating preferred stocks above the day they become callable coincides with the day they switch from being a fixed rate instrument to a floating rate instrument. What does that actually mean? Let's imagine you buy one of these fixed-to-floating preferred stocks, for example USB-M. And you hold it until 2022 when it switches from being a fixed rate instrument to being a floating rate instrument. On the date USB-M becomes a floating preferred, two things could potentially happen in a perfectly rational world. One, if the spread above LIBOR that U.S. Bancorp has to pay for newly issued bonds is narrower than when it originally issued USB-M, then it could call USB-M and substitute it with a new bond with a lower interest rate. Two, if the spread above LIBOR U.S. Bancorp has to pay has widened, the bank chooses to leave the issue in play.
Let's consider the two cases separately. First, if U.S. Bancorp redeems the issue at par at the call date. Then your realized yield if you hold the issue to that date would be the yield to call. Second, if U.S. Bancorp's cost of debt has increased at the call date, then the bank would opt for not calling the bond. And if that's case at the call date the bond would be trading below par to compensate for the increased credit risk. Then your realized yield would be even lower than the yield to call. There is a third scenario as well, which I didn't mention before. Let's assume that it does not make economic sense for U.S. Bancorp to call the bond, because it would be paying a higher spread over LIBOR. Then, if prevailing market expectations are for rising interest rates, the bank could still call the issue to protect itself from the risk of paying a higher interest rate in the future.
Now consider the call option itself. When you try to make sense of the fixed-to-floating preferred stocks it is important to remember that the issuer is long the call option embedded in those securities. In a rising interest rate environment, the call option gets more and more in the money and thus is more likely to get exercised. Moreover, when interest rate volatility increases the option value also increases. It is also worth considering that there is a body of research indicating the level dependence of interest rate volatility, i.e. when interest rates are low, their volatility is high. So, now when the interest rates are at historic lows, you can reasonably expect their volatility to be high which makes the value of embedded call options in fixed income securities more valuable for the issuer.
Before I continue with my thoughts, I want to make one quick caveat - all my reasoning is based on the premise of a perfectly rational market participant. And as we all know, there are no perfectly rational people. But it's still good to think from the perspective of such an imaginary being, as this helps you understand what the financial logic behind fixed-to-floating preferred stocks is.
So what does all this mean? My take is that, if you are planning to hold a fixed-to-floating instrument until its call date, then its current yield to call is the best yield you can hope to achieve. If the creditworthiness of the issuer deteriorates in the meantime, even if it is still able to make payments, your realized yield would be lower.
What are the implications of all this? Let's look at some hypothetical scenarios and see how a fixed-to-floating preferred stock would fair against a plain fixed rate preferred stock with both securities having the same call date. If the issuer's creditworthiness improves and it is able to refinance its debt at a better rate at the call date, it is clear that both securities would be called at that date. What would happen if the issuer's creditworthiness has deteriorated? Then he would call the fixed rate preferred stock if the interest rates have moved lower and would call the fixed-to-floating preferred stock if the interest rates are expected to move higher.
In the current macroeconomic environment we are expecting interest rates to go higher especially after Trump's election, so I will focus on that scenario. In a rising interest rate environment the likelihood of a fixed-to-floating preferred stock being called at its call date increases, so if your holding period coincides with the call date, you should be looking at the yield to call as the proper metric in your analysis. The relevant metric for fixed preferred stocks, however, would be the current yield as those securities are unlikely to be called in a rising interest rate environment. One more thing to consider, since fixed-to-floating preferred stocks are more likely to be called at their call date, they have shorter duration than fixed rate preferred stocks, which makes their price less sensitive to rising interest rates.
Ok, enough theory. Let's see what does all this mean for the fixed-to-floating preferred stocks I listed above. First, a quick note about GS-D - that preferred stock has an embedded floor option, which makes its behavior even harder to understand in different macroeconomic environments. I just included it here to show you that financial engineers could come with all sorts of peculiar features for fixed income products and bundle them together, so it always pays of to check the security's prospectus before you jump in and buy it.
For the other preferred stocks, as I mentioned before, it's best to focus on the yield to call as the relevant metric. And there are some dogs and some stars in the list above. ALLY-A is clearly a decent buy at 25.08 with an yield to call of north of 25%. Even if you believe that GMAC will not call it, I think that a current yield of 8.10% is alright for a B-rated bond. WFC-Q looks even better at its current levels. I think that 5.71% for a BBB-rated preferred stock is a handsome compensation. A quick search in Finra shows that bonds of other U.S. banks maturing in 2023 with ratings around BBB are yielding around 3.00%.
On the other hand, you clearly need to stay away from USB-N. Its yield to call is ridiculously small and if you buy it now, you are risking a call in just a couple of months time.
One last thing - I wanted to see how WFC-Q fairs against fixed rate preferred stocks of Wells Fargo. The most relevant of those seems to be WFC-W, which has similar nominal yield and similar call date. More details below.
Source: Author's spreadsheet
As I mentioned earlier, for fixed preferred stocks current yield is the more relevant metric and you can see here that this yield is slightly higher than the yield expected from WFC-Q. Bear in mind, however, that the duration of WFC-W is much higher than that of WFC-Q, so you will be bearing a higher interest rate risk if you opt in for buying WFC-W. In the current environment, I myself prefer having some interest rate protection in the form of lower duration even if it comes at the cost of a slightly lower yield.
Some fixed-to-floating preferred stocks are starting to look attractive at their current levels, but it pays to understand how to interpret each stock's metrics and behavior before you get into a position. I wouldn't go all in and indiscriminately build positions into fixed-to-floating preferred stocks in order to have less . As always, it is much more productive to look for the diamonds in the rough.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.