During the great recession I traded professionally, focusing on illiquid and poorly understood securities. My level of involvement in these markets often resulted in me serving as the unofficial market maker. Many of the best risk adjusted and most profitable opportunities at the time were the thinly traded and little known preferred equity of financial institutions. As proof, Seeking Alpha itself doesn't even host ticker pages for preferred shares, and there is little to no consistency in preferred ticker listings among brokers and search engines like Google Finance and Yahoo! Finance,. All these seemingly innocuous characteristics reinforce the "fog" of preferred investing. Uncertainty and ambiguity often provide investment opportunity to the trained eye.
As the energy sector continues its death spiral, it feels like deja vu as once trusted names deteriorate toward penny stocks with all levels of the capital structure hemorrhaging losses, while bankruptcy risk is argued by market participants.
Preferred equity investors are particularly distraught, as they know anything less than a 100% recovery by creditors means they will suffer a total loss. They also know, however, that if the firm evades bankruptcy and ever pay another common distribution, it is almost certain they will trade near par once again and pay their stated distribution rates - even if those distributions are delayed.
Some C-Corp and master limited partnerships, or MLP, energy companies do not have preferred equity within their capital stack, but many do. You can see from my article archive on Seeking Alpha that I have written extensively on the energy sector, particularly the upstream segment.
Preferreds trade abnormally during periods of high volatility and uncertainty because they have low liquidity and act as a "Yes or No" security. What I mean by that is the possible outcomes are limited and straightforward:
- The common stock survives. The preferred will eventually trade back to approximately par (this usually occurs very rapidly once it becomes clear insolvency risk is mitigated) and all distributions are received be it quarterly or in a lump sum once management gives the "all clear" signal for cumulative preferred shares.
- The firm has to be restructured/becomes insolvent. Preferred equity in this case highlights the equity part of its name and becomes worthless. Distributions may or may not be paid while it slides toward zero.
That's it. There really is no in between because preferred equity distributions generally (every case I've seen for cumulative but the terms can theoretically be customized) must be paid, including those skipped in the past for cumulative preferred shares, before the common equity or units receive any kind of dividend or distribution. It is worth remembering that management is paid in common equity rather than debt or preferred equity so you can guess where their hearts tend to lie.
The Lucky Few
I have not attempted to nor have any desire to include every preferred stock in the energy space in my comparative analysis. That being said, most names outside of utilities are likely within Part I or Part II (in progress). Most of these names I have followed for years and many of which I have written at least one in depth article on here at Seeking Alpha in 2015. They cover the spectrum in terms of risk and segment of the energy sector excluding utilities. As always, I recommend checking the prospectus of each preferred for unique characteristics that may not be reflected in my chart. Quantumonline.com is valuable resource I suggest supporting if you find it useful. Part I encompasses both upstream MLPs and midstream companies.
I developed a simple linear scale to rate the risk of each security that is based on qualitative and quantitative factors but namely yield on cost.
The table goes from blue for low risk securities to a bright red for those highly likely to suffer total losses. As you'll see in the spreadsheet, it is already "game over" for several preferred stocks. I included these a friendly reminder that preferred stocks can and will go to zero under the right circumstances.
The formatting of each preferred's ticker is the methodology used by Quantumonline.com and Google Finance. Yahoo! Finance requires a "-p" designation such as GST-pA for GST-A. Brokers' treatment of symbols vary.
Upstream Master Limited Partnerships
*Fixed-to-Floating Rate on and after 4/24/2024.
The first point to make is the market does not have much confidence in any upstream MLP's preferred shares. For Atlas Resource Partners (NYSE:ARP), the market and I are in agreement that while not imminent, bankruptcy risk is real in the next 12-24 months. We have a slightly different opinion of BreitBurn Energy Partners (BBEP) in that while I am still very concerned about the firm's future, I do not think bankruptcy risk is quite as high as the market does. Vanguard Natural Resources (NYSE:VNR) is a better operator and less leveraged than the two prior names and the market recognizes this with yields on cost for its three issuances approximately half that of Breitburn and Atlas Resource Partners. I got long VNRBP in the $12-14 range so I've sustained substantial unrealized losses. I am patient and plan on holding the position for however long the commodity downturn lasts unless something changes in terms of Vanguard's strategy or operational efficiency. I consider the B and C classes slightly better values than the A class for the simple reason the risk is essentially the same yet they yield 3-4% more on cost and subsequently have higher potential capital gains (by a significant margin) if VNR survives.
The most interesting part of the upstream space is no doubt Legacy Reserves (NASDAQ:LGCY) preferred shares which are priced as very high risk by the market and trade at a mere 25% of par. Investors will see nearly 400% in capital gains if Legacy survives without restructuring. I disagree with the market here; Legacy is no more risky than Vanguard and substantially less likely to become insolvent in the near future compared to ARP and BBEP yet trades at a similar yield at cost of ~40%. I struggle to make a valid counter argument to this opinion. Of the upstream space, Legacy's two preferreds are by far the most miss priced by the market. As always, please reference what its debt is trading at to ensure the preferred is a good value. A quick note here: be careful not to compare yield on cost of the preferred to the yield to maturity ("YTM") of the bonds - that is not apples to apples because the preferred will experienceapproximately the capital gains stated in the table if the firm survives long term. Interest rates and other factors will determine how close to par the preferred will ultimately be priced.
No orange or red here by the market or me. That being said, I think the risks for these particular names are generally a bit higher than the market does. I'd want to be compensated with slightly more potential return and yield on cost for Teekay Offshore Partners (NYSE:TOO) and the Kayne Anderson MLP investment Company (NYSE:KYN) family of securities. Kayne's three largest holdings are Enterprise Product Partners (NYSE:EPD) at 13.7%, Energy Transfer Partners (NYSE:ETP) at 12.0%, and Williams Partners L.P. (NYSE:WPZ) at 8.2%; all of which are strong firms with healthy balance sheets and fairly conservative management. It does have meaningful exposure to more leveraged firms (e.g. Kinder Morgan (NYSE:KMI) at 7.4%) and a little (2%) to shipping MLPs. This means KYN's "insolvency" risk is essentially zero but that does not mean its common stock's low double digit yield is not at risk if the commodity downturn is sustained. Given so many individual names (as well as KYN's common stock) offer much higher yields, I'd want to be better compensated. I'd also wait for a little lower price on CorEnergy's (NYSE:CORR) preferred given the firm has a very large concentration issue with infrastructure related to struggling Energy XXI Ltd. (EXXI) which interestingly enough appears in Part II; otherwise I think it is a solid infrastructure REIT with high growth potential. Targa Resources (NYSE:NGLS) is in my opinion fairly priced at current levels.
In Part II, we'll cover the rest of the exploration and production sector, which includes another 15-20 securities, several of which are on the brink of bankruptcy.
Thank you for reading, and as always please follow me if you'd like to read similar analysis in the future. I also strive to reply promptly to all private messages from followers.
Disclosure: I am/we are long MCEP, MEMP, GST-A, LNCO, WPC, VTR, HCP, HTA, DOC, VNRBP, MAIN, BXMT, RY, BNS.
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: The author may enter into long or short positions in any part of the capital structure of any of the firms mentioned in this article. Readers should always conduct their own independent due diligence and not rely upon information or opinions provided by the author.
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