The fixed income rally has been relentless. The 10 year T-note is just below an all time high and TLT, the 20 year, closed yet again in uncharted territory. Fixed rate preferred stocks are mostly trading way above par and even the unloved fixed to floating preferreds have recently rallied.
Investing in fixed income is getting more and more difficult, Shorter term trades are especially hard to come by. Finally I have found an arbitrage, but they are so rare I am actually suspicious. Have I overlooked something? I find that writing my thoughts down and sharing ideas with knowledgeable readers helps clarify my process, so here goes:
Floating rate preferred stocks
These preferred stocks usually pay the higher of a certain fixed rate, or LIBOR plus a certain spread.
As mentioned above, floating rate preferred stocks have enjoyed a rally recently. This can be credited to a number of factors.
They are the only preferreds issued by quality names that trade under par. Even though the fixed part of the yields are relatively low, compared to some of the overpriced fixed rate issues - many of which have negative yield to call - they are still desirable. Would you rather have 3.8% yield for the foreseeable future, or a 6% yield that could result in a 20% capital loss at any time?
The rally also began around the same time as many fixed to floating rate preferreds were redeemed. These redemptions resulted in some huge capital gains for holders. UBS-D jumped 52% on redemption, HUSI-F,G, and H were redeemed when they traded around 10% below par.
I wrote about these at the time, and, after some debate in the comments section as to why issuers were redeeming, it was generally thought there must be some banking regulations forcing them to do so. Whatever the reason, it seems buyers have pre-emptied any further redemptions.
Here is a closer look at how some of floating rate preferred stocks performed recently:
Is the lag in GS-D (used as an example) warranted? Let's compare the fundamentals to other fixed to floating preferreds:
Clearly there is very little difference and there is no fundamental reason for GS to be trading this cheap, or for BAC-E to be so expensive. I have observed a large block seller on the books in GS-D, and this has been halting any advance. As an investor, I would never pay $24.50 for BAC-E when GS-D is available for $21.13. I would be very interested to hear why anyone would (without any insider information about a possible redemption).
Fundamental comparison with ZB-A.
Fundamentals are again in favor of GS-D. ZB-A has almost 0 capital appreciation potential, even if for some crazy regulatory reason it gets redeemed. Why lock in a 4% yield when you can lock 4.7% by switching to GS-D?
Fundamentally the arbitrage seems quite big, but when we look at statistics, this is not really the case.
Price spread comparison to ZB-A.
The fundamental arbitrage is where the current yield becomes equal or close to $3.5. On the other hand the statistical arbitrage is just around $1. This is definitely not the trade of a lifetime, but I also try to switch between such issues. GS-D compares similarly to almost all other stocks from the LIBOR family so there are a lot of hedging opportunities.
I am long GS-D with an average price of 20.75 (there was an enormous seller helping me get a good entry). I will hold this position naked long as long as the arbitrage narrows. Hopefully for me it will narrow in my direction. I am considering hedging my position with a short portfolio of BAC-E, ZB-A, USB-H as well as some fixed to floaters that are at record highs. What makes me naked long in the current situation is the parallel shift in the yield curve and the lagging behavior of GS-D. Shorts are really expensive in such tiny traded stocks. My average hard to borrow rate for the month of June was above 20% which is hard to beat with a 4% arbitrage trade.
In times when "buy the dip" is the simplest and best working strategy, a small arbitrage in low volume stocks is not very interesting to most investors. This might not be the trade of your life, but it is a good example of how similar products are treated in a different way by the market.
Note: Panick Value Research Report members had an advance look at this article. A 2 week free trial of the Panic Report is available in the Dividends section of the Seeking Alpha Marketplace.
Disclosure: I am/we are long GS-D, MS-A, GS-C.
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.