Since the beginning of the year, I have noticed quite a few arbitrage opportunities, mostly in CEFs. You can read about some of them in my previous articles from earlier in January. Preferred stocks, which I also like to track, have been quieter recently, and I haven't noticed too many mispricings in those. That was until today, when two of Public Storage's (NYSE:PSA) preferred stocks caught my eye. I am talking about the Series W 5.20% Cumulative Preferred Stock (NYSE: PSA-W) and the Series X 5.20% Cumulative Preferred Stock (NYSE: PSA-X). In my opinion, both securities have strayed too far away from their siblings and have become overpriced in relative terms. You can clearly see that in the table below, which compares PSA-W and PSA-X to two other PSA preferred stocks.
Source: Author's spreadsheet
For a comparison with all brother stocks, you can look at this table:
Source: Author's Database
I have chosen the Series B 5.40% Cumulative Preferred Stock (NYSE: PSA-B) and the Series T 5.75% Cumulative Preferred Stock (NYSE: PSA-T) because of the strong correlation among the four selected securities in the table above. First, notice that all four preferred stocks bear the same credit risk (rated BBB+) and are ranked pari passu in PSA's capital structure. Also, all four instruments are trading below par, which means that the market considers them as unlikely targets for a potential call from the issuing company. That's why when you compare those preferred stocks among each other, it is useful to think of them as perpetuities, rather than as fixed income instruments that are likely to mature in the near future. And for securities treated by the market as perpetuities, it might be best to focus on the current yield as the relevant metric to compare one to another.
That being said, it is clearly visible that PSA-T and PSA-B are much better alternatives than PSA-X and PSA-W, because the former offers significantly higher yields. PSA-T and PSA-B also have higher nominal yields, which is very attractive in a rising interest rate environment. Since the Fed is already taking a hawkish stand and the proposed policies of the new president in the USA are likely to lead to higher inflation and both higher real and nominal rates, it is no surprise that market participants have been trying to limit their exposure to interest rate risk. One way to do that is through investment in instruments with higher nominal yields such as PSA-T and PSA-B. So it is a real puzzle to me that all the recent demand for PSA's preferred stocks has been soaked up by PSA-X and PSA-W, leading both securities to such high price levels.
Another way to see the mispricing of both PSA-X and PSA-W is through looking at the historical relationship between them on the one hand and PSA-T and PSA-B on the other. I won't be looking at all pair-wise comparisons, but wanted to show you two examples in the pictures below.
Source: Author's software
Source: Author's software
First, notice the strong linear relationship between PSA-B and PSA-W with the correlation between the two preferred stocks being 0.98. The correlation between PSA-X and PSA-T is similarly strong at 0.95.
Now let's focus on the top panel. It shows the relationship between two hypothetical equally valued portfolios - portfolio 1 invested in PSA-B and portfolio 2 invested in PSA-W. One would expect the two portfolios to track each other very closely and they have done that for pretty much the entire 200-day period represented in the picture above. Recently, however, the relationship has been broken somewhat and that is clearly visible in the chart at the bottom right corner of the top panel. The chart shows the spread between portfolio 1 and portfolio 2 and under normal circumstances that spread should revolve around 0. But in the past days that spread has deviated considerably from 0, and I see such a deviation as a clear indication of a mispricing taking place.
The bottom panel shows a similar story for two other portfolios - portfolio 1 invested in PSA-T and portfolio 2 invested in PSA-X. In this case the historical relationship between the two portfolios is less pronounced, but nevertheless, there is clear divergence between the prices of PSA-X and PSA-T.
All the arguments I mentioned so far are speaking of a mispricing in PSA-X and PSA-W. Nothing fundamental has changed with those two securities, so I propose a pair trade that would be constructed in such a way as to take advantage of the current mispricing. Since PSA-B seems to be better aligned with PSA-W (and PSA-X, which I haven't shown here), I propose a pair trade with the short leg being PSA-X/PSA-W and the long leg being PSA-B.
With the proposed trade I am betting on the price spread between PSA-X/PSA-W and PSA-B tightening and returning to historical levels. If you are not into pair trading, you might also consider a naked short position in PSA-X/PSA-W, but I would advise against such a decision since by doing that you will also be betting on the general direction of interest rates. If you currently have a position in PSA-X/PSA-W, then the best approach would be to cash in and move on to any of the stocks' siblings which are offering a much more attractive yield at the moment.
Author's note: PSA has the best preferred stock management ever, and it is really hard for me to understand how the market makes such an obvious mistake. I will not be surprised if PSA itself starts to narrow the arbitrage (if it could) by selling PSA-W and PSA-X and buying from the others. It does care about a 0.40% yield spread.
In this article, I tried to tell you about a mispricing occurring in some of PSA's preferred stocks. PSA-X and PSA-W have moved too high in relation to their other siblings, which represents an opportunity to either unload positions if you have holdings in the securities, or to engage in pair trading in order to capitalize on the current discrepancy. If you are a long-term investor and are looking for securities to buy, then my advice would be to stay away from both PSA-X and PSA-W and look into the other PSA preferred stocks. For example, at a current yield of 5.91%, PSA-T looks to be a much better investment opportunity than either PSA-X or PSA-W.
Disclosure: I am/we are short PSA-W.
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: I am long PSA-E