In last week's "The Best Fixed Rate Preferred Stock" article, we crowned WFC-L the current king of rated stocks. However, the 6% current yield is hardly awe inspiring, and I received many comments suggesting the best place to look for yield is in the unrated preferred stocks. What better place to look for income than the REIT sector? The whole REIT idea was to benefit the income seeking investor. REIT preferred stocks are a unique vehicle, because they have the much loved cumulative clause, and even though their dividends are not qualified, they can still perform well in accounts that have tax benefits.
Filtering the stocks.
There are around 150 unrated REIT preferred stocks. These vary markedly in quality, yield and duration. We could spend a few weeks analyzing each issuer, but it wouldn't really aid our search; the company may be great, the yield may be great, but the price may be anything but. What we can do is filter down the group as a whole, gradually weeding out stocks we don't like until we have a few that meet our criteria. I will guess before I even start my search that the mother companies of these stocks will be of decent pedigree. In a way the market does our research for us. Nevertheless, it can do no harm to do your own due diligence, and there are Seeking Alpha authors with excellent articles on the REIT sector to aid your research.
Yield too low
The best REIT preferred stock must be unrated, as if it was rated it would have shown up in my previous article. If I can find a 6% yield to worst in a BBB rated perpetuity (WFC-L), an unrated and unqualified preferred stock from the REIT sector has to give me at least 1% premium. Therefore anything with a yield to worst of <7% is excluded.
Yield too high
Of course we want the best yield, but not at the cost of safety. There's always a trade off and in current market conditions you will have to take on a fair amount of risk if you want high yield. Where a few months ago we might have been looking at 10% as a cut off to exclude risky stocks, now anything over 8% is hazardous. The market is not giving you over 8% as a present. It is telling you something and you should probably listen.
When assessing risk, our main concern will be the behavior of the common stock. It is a simple trader's logic: if I have two similar preferred stocks with similar characteristics, I will always prefer the one with the rallying common stock. We will use the ratio of market capitalization of the common stock divided by that of the preferred stock over a 100 day period. If this ratio is at its highs it makes the preferred a laggard and an investor would most likely have a reaction to cover his preferred position without significant loss if the common stock starts selling.
Yield to call <0
Yield to call that is negative means "no" for me. There's no point including stocks from this group if you are looking for the best yield.
Current yield > yield to call > 0
This is the group of possible calls and is interesting to me for 2 reasons:
- It can give me a candidate with a decent current yield that has a yield to call >5% and a call date sooner than 2 years. This makes the possible redemption not such a bad alternative. Imagine a 5% yield to call in 1 year, and a current yield of 5.5%. 5.5 is obviously higher than 5, but this does not necessarily mean that 5% in one year is worse than 5.5% perpetuity.
- It can give me an idea of what nominal yields are treated by the market as possible calls.
Now we have filtered down to a group of stocks we like, we can look closer at the candidates:
Annally Capital (NYSE:NLY) preferreds were my favorites on the last sell off in the market, and although it is hard for me to buy them here, numbers are numbers:
As stated above my view has always been that of a trader so I am really concerned with the price behavior of the common stock. In this case, as seen in chart above, there is nothing to worry about. The market cap ratio is at its highs for the last 100 days so this adds extra protection and room for hedge on any bad news in the company.
I personally exclude this one as I don't see a rally in the common stock. I know that many people will argue this approach, but every long I take has to have a plan B and when you see the majority of REIT commons making new highs, there has to be something wrong with this company. You lose nothing by not buying a preferred stock at $25.46. It will not open at $50 tomorrow.
ABR-C is definitely worth watching with this 1% premium over NLY preferreds, but a preferred stock yielding >8% needs further due diligence or at least size management. Here you can see a comparison between NLY-C and ABR-C:
We are currently very close to the averages in these two stocks, so statistically there is no arbitrage in them at the moment. The reader will have to read more to decide which one is better for him.
There is nothing much more to say that hasn't been said already by Brad Thomas in his excellent article. The most important argument for me is the "put" option of this preferred stock. I bought this one at $25.25 after reading the article and will let it run for a while. The one thing that bothers me about stocks like this is a good debtor rarely gives such good clauses. What is usually considered a plus in the prospectus can turn out to be a sign of weakness.
The group of perpetuals.
Current yield here is lower than yield to call. This tells us that the market does not expect any of these stocks to get redeemed. If you have reason to believe that any of them will be redeemed you can add some capital gains to the generous current yield. Let's look at the candidates:
I have written an article about CYS preferreds when they were real bargains and the reader can find some more information there. My CLNY article was also a trading success for me and I encourage you to read it as well. AMTG and HTS are merger stocks for me and I never invest in such stocks with an income perspective. A merger risk is something that I don't need in my income portfolio. As a trader I want to buy before the merger news hits the market, so for me those issues are a "do not touch".
The one that stands out for me from this chart is American Capital Agency Corp AGNC. It has 2 preferred stocks AGNCP and AGNCB. Currently AGNCB is the better choice for me, because of its 8% yield to call:
There is nothing to worry me here and I am really interested in this 7.7% current yield. The mother company has 9 years history of paying dividends:
It is really hard to be a long term investor in a company that has not been tested in tough times, but the current dividend payout ratio of 12.6% is nearly 0.9 bln a year. The nominal value of preferred stock the company has is around 0.325 bln. This is a ratio that gives extra certainty to preferred stock holders. The 26 million preferred dividends yearly are a tiny amount, compared to the common stock dividend. Both preferred stocks behaved quite well compared to the sector on the last sell off in the REIT preferreds, and this adds some certainty, even though we traders can have naive thinking and tend to miss the big picture sometime.
AGNCB vs NLY-C:
For the last 100 days AGNCB was trading at the same price as NLY-C and at almost the same current yield. Currently the potential statistical arbitrage is around 60 cents. It is not something to bet all your savings at, but for preferred stocks with almost 90% correlation it is not a bad deal from my perspective. I encourage any one to read this really detailed article and especially the part with NLY- AGNC comparison. The article discusses the common stock dividend and it might be cut. This in fact can be treated as a good news for preferred stock investors. If the company is currently overpaying dividends it brings risk for its preferred stock. A cut is healthier in the long run and will add more certainty to senior preferred stocks.
The main contestants
NLY-C - used as a benchmark
AGNCB - based on short term statistics and higher yield
BRG-A - the best clauses in the prospectus plus the very rare put option in preferred stocks
ABR-C - it is all about the high yield (dividend suspension in the common stock in the past makes me pass on this one)
These are my top 4 picks. But there can be only one winner. Because I value statistics and the reaction I can have should go anything go wrong, my winner is ...AGNCB. I will be glad to hear yours and to turn discuss further in the comments section.
Given the current rally I sometimes feel like there is almost nothing left to buy. I would certainly prefer to buy my top 4 picks on a correction rather than when they are making new highs. Regardless, the AGNC issue, AGNCB, is currently my champion of REIT preferreds, and an 8% yield to call is never a bad addition to your portfolio.
P.S. As I am writing this article there is a sell off in the REIT sector and in TLT. Hopefully we will have another correction. It is quite possible that this is not the time to buy, but to hedge, sell or short.
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.