A Guide To Investing In Preferred Shares

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Includes: AGNC, ARR, NLY, NYMT
by: Colorado Wealth Management Fund

Summary

Investing in preferred is like a cross between analyzing stocks and bonds. The dividend preference for preferred shares can be a huge advantage.

Most of the relevant information can be found within the prospectus.

By targeting my research to a small niche, I’ve been able to find several opportunities where there was material disconnect between risk and reward.

Three recent examples show disconnects where a single company (different company each time) saw different series of preferred stock offer substantially different risk/reward profiles.

This article was a joint effort between a subscriber of The Mortgage REIT Forum and Colorado Wealth Management Fund. With their explicit written permission, I am publishing it publicly.

Before you invest in preferred shares, there are a few things you should know to maximize your effectiveness. By paying attention to a few details you will feel more confident about your trades and you will have a stronger grasp of the dynamics of this exciting part of the market.

As a trader and researcher I spent many years learning the strategies of investing in preferred shares. About three years ago I realized I want to share my experience with other investors and traders. For that reason I write some public articles and some subscription articles.

Whether you are a trader or a long-term investor, a novice or an old-timer, let's take some time to review the basic elements of successful investing in preferred shares.

PART 1: How to Invest in Preferred Shares

--Like a stock, a preferred share moves up and down in price with the market forces.

--Unlike a stock, a preferred share can be called back by the issuing company at a fixed price, normally, $25.

--Like many stocks, a preferred stock pays a dividend, fixed by a contract known as a prospectus. All preferred stocks pay a fixed dividend. This causes many people to compare them to bonds, which also pay a fixed dividend.

--Unlike a stock, the dividend remains constant throughout the life of the preferred share. Because the dividend if fixed, they are compared to bonds, which also are fixed.

--Like a bond, a preferred stock has a call date or a maturity date. The issuing company may or may not call the preferred shares on the "call date." If the share is called, the company gives the agreed amount (usually $25) to the investors and then retires the shares.

--Preferred shares are called "preferred" because these shares have dividend preference over common shares if the company is in a financial bind.

--Because preferred shares have a dividend preference over the common and because the price of the shares tend to be stable, many people think of preferred shares as having minimal risk.

--Preferred shares of stock are issued with a prospectus, like common shares. The prospectus is a contract between the company and the investors. In the prospectus you will find the issue price, the call price, the date the shares are eligible to be called, and, of course, the dividend amount. These elements form the basic contract between you and the issuing company.

Of all the many hundreds of preferred shares on the market, I limit my research to a small segment - the Real Estate Investment Trust segment, or, REITs. The mortgage REITS are companies which buy and sell mortgages for individual homeowners and corporations. Each REIT has its own style and focus. We will discuss this is more detail later. I focus on REITs and their preferred shares because I find this a profitable niche of the market. Lately, I've found working the preferred shares tied specifically to mortgage REITs, as opposed to equity REITs, to be particularly appealing.

For the past few years I have focused my energy on the REIT market for my own portfolio. I developed highly-accurate modeling techniques and have a successful track record of investing and anticipating price moves in the REIT market. With the advent of Seeking Alpha, I decided to share my research with a larger audience.

Let's begin with a basic chart. In our first chapters of this guide, we will look at the following items in the chart below, explaining them in detail.

Two Sample Preferred Shares of REITs (Fictional)

This chart shows that USMortgage, ABC-p, was issued at $25, but now has increased in price to $26.25 - a premium of $1.25, or a 5% premium. The important factor for ABC-p is that the shares can be called as soon as August. If that happened, the investor would receive $25 for the share and the premium would be lost. Ouch! Too risky for me!

In contrast, ColoradoM, DEF-p, was issued at $25 but now trades at a discount price of $24.57. DEF=p cannot be called for another ten years! That gives it great call protection and assures the investor the shares will pay $1.83 per year for ten years --- for a total of $18.30. The only thing that can change that returns would be a failure of the underlying company. DEF-P could be a terrific, long-term, stable source of income in a retirement portfolio.

It is rare to find an opportunity where the risk is skewed as dramatically as it is in this example, but it is not uncommon to find differences in the risk/reward that I consider very material.

Allow me to provide some pieces where I've called out a material disconnect in the risk/reward ratio:

Annaly Capital Management (NYSE:NLY) sees NLY-C and NLY-E moving apart. In this case there was an opportunity for investors to sell NLY-C at the bid and buy NLY-E at the ask while receiving between $150 and $190 in cash per thousand shares. The dividend rate is precisely the same and NLY-E has more call protection. When the investor can sell NLY-C and buy NLY-E at a lower price, they are simply capturing the spread between the two.

ARMOUR Residential REIT (NYSE:ARR) offering 5% more income on the B series. The two preferred shares for ARR carry different dividend rates, but the price difference was larger than the dividend difference. Consequently, the investor had an opportunity to grow their income by 5% for swapping between the two. Getting a 5% boost to income is massive in this area. The goal is to find marginal increases. Rather than hitting home runs, this is supposed to be about finding tons of singles. Getting 5% more income on the same risk is much more than a single. When I highlighted the difference, I also used a comparison with the preferred shares of AGNC Investment Corp. (NASDAQ:AGNC):

Notice that ARR-B carried a 9.03% yield, compared to the 8.6% yield, and also traded at a much larger discount to par value. The image doesn't show the difference in the call eligibility dates, but ARR-A's call protection expired much sooner. For investors who expected a call, that might seem positive. It isn't. A mortgage REIT doesn't call preferred shares that can be bought back for less than call value. If they want to retire the shares, they can simply begin buying them back in the open market.

New York Mortgage Trust (NASDAQ:NYMT) offers more income and better call protection for one series. Like the case with ARR, the two preferred shares had different dividend rates. However, the one with more call protection was also offering a significantly better yield and a better discount to call value. Take a look at the chart below:

It doesn't just happen within the preferred shares for a single entity, but those opportunities are highlighted to prove that the market will occasionally make very material mistakes in pricing the preferred shares. If it can happen between two series of preferred stock for the same company, how much easier is it for the risk/reward ratios to disconnect when the securities are from different companies?

The answer is that it is substantially easier in those cases. That is why investors should be looking for alpha in preferred shares. The combination of strong yields and inefficient markets makes it an exceptionally interesting area to invest.

For a recent example on the absurdity of these movements, consider American Capital Agency Corp . Their series B preferred shares traded at a low of $25.05 and a high of $26.05 within the last week. They were a solid buy at the lower price, but are a clear sell at a higher price. The trades were about 72 hours apart.

I intend for this to be a short series, so make sure to follow me if you want to see the next few parts.

This is your opportunity to lock in prices at $300 per year before the next price increase on April 1st, 2017. Rates are going up because of the high cost of providing such detailed analysis. By signing up today, your price is locked in against future increases. If you want to learn more about investing in high yield instruments, specifically mortgage REITs and their preferred shares, check out the reviews from my subscribers. My subscribers have access to a model I use to track target prices for strong buys, buys, and sells. It updates in real-time (20 minute delay) and shares light up when they enter any of the ranges. In the last month I was able to correctly call the opportunity in shorting Orchid Island Capital (NYSE:ORC) (about a 20% return), shorting Western Asset Mortgage Capital (NYSE:WMC) (for a 6% to 7% return) which included a release when shares hit the target range to close the trade, and buying Resource Capital Corporation (NYSE:RSO) (up over 17% in a week) going into the earnings release.

Disclosure: I am/we are long RSO.

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: Also long preferred shares of NLY and CMO. I have open limit-sell orders at prices higher than the last traded price. If the bid were to reach those levels, my shares would sell.

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