5 High Yields To Keep Your Portfolio Safe With Preferred Shares

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Includes: AGNC, AGNCB, AI, AI.PB, ARI, GOOD, MORT, NLY, NLY.PF, NLY.PG, NNN, O, PEI.PC, PEI.PD, PFF, PGX, REM, TWO, TWO.PE, VYM
by: Colorado Wealth Management Fund
Summary

Many investors look to ETFs or dividend champions for a steady income. We believe investors should invest a portion of their portfolio in preferred shares.

We’ve found preferred shares provide an excellent opportunity for investors to get a high yield with lower volatility.

NLY and AGNC are two of the companies we will be covering today that offer preferred shares with a risk rating of 1.

ETFs such as REM and MORT have a high yield but come with a material amount of volatility and an expensive expense ratio.

Preferred shares have been a major source of our returns. That includes buy-and-hold opportunities and trading.

100% of our revenue from this article in the first month will be donated to a charity. In January, we will be supporting 2 Blondes All Breed Rescue.

There is no perfectly safe investment.

Even cash can be stolen (often not covered by insurance) or the value can be inflated away. We mainly focus on low-risk investments and have done quite well at it.

Winning consistently is a function of finding a niche. Buying outside the niche means effectively picking blindly. We stay in our area of expertise to benefit from the knowledge base we've built. Many retirees want monthly income coming from high yields and don't know which individual shares to buy. We cover the individual shares every week for subscribers and we provide a few public articles on individual preferred shares to help more investors succeed in the area.

We cover these shares every week on The REIT Forum with suggestions about which ones to buy and which to sell. We do it with our positions and history clearly shown.

Here are some of the things we cover:

  • Buy-and-hold investments

  • Trading opportunities

  • Finding good entry prices

  • Using our price targets

  • Total returns

We’ve found preferred shares provide an excellent opportunity for investors to get a high yield with lower volatility. Some of today’s picks come from our latest article for subscribers: Preferred Shares Week 135.

Taking a look at preferred shares with a stock analysis tool

We will be looking at preferred shares from AGNC Investment Corp. (AGNC), Arlington Asset Investment Corporation (AI), Annaly Capital Management (NLY), and Two Harbors (TWO).

Source: The REIT Forum

Rates moved higher on the week, but preferred share indexes climbed slightly. We’re still seeing some attractive values in the preferred shares, though some of our favorite opportunities rallied out of the ranges that made them so appealing.

Annaly Capital preferred shares

Last week NLY-F (NYSE:NLY.PF) dipped back into the strong buy range and was featured in ‘Preferred Shares Week 134’. It rallied $.35 on the week.

Meanwhile, NLY-G (NYSE:NLY.PG) dipped $.19 over the last week. The result is a substantial spread between their share prices. At a spread of $2.02, NLY-G looks like a significantly better deal than NLY-F.

Buy-and-hold investors won’t need to ditch their NLY-F in favor of NLY-G. They certainly have that option if they want to reduce their call risk, but it isn’t necessary. NLY-G has a smaller floating rate after call protection ends, so NLY has less incentive to call it. We believe it is quite unlikely that NLY-G will be called. If a call happened, investors with a cost basis of $23.03 would be thrilled with the result.

NLY-G has become much cheaper relative to NLY-F:

So why is NLY-G getting so much cheaper compared to its sister share?

The answer appears to lie in investors (or computer programs) disregarding the call risk and pricing the shares as perpetuities. The difference in the spread over 3-month LIBOR (or whatever index replaces it in the future) is enough to justify a material difference in prices. However, if investors are even a little concerned about call risk, they should favor NLY-G when the prices are spread this far apart.

So how far apart should the two shares trade? We’ve tended to figure that it should be around $1.30 to $1.40. A logical case could be made for going up to $1.50 or so. Currently, the spread is $2.02.

If NLY didn’t have the right to call the preferred shares and we assumed that a 7% discount rate was reasonable, then a spread of about $2.54 would make sense. At an 8% discount rate, it drops to a difference of $2.26. and at 9% it would be $2.04. If investors feel a 9% discount rate is absurdly high (given current stripped yields around 7%), we agree.

However, preferred shares often encounter more resistance to moving more than a few cents over $25.00 because many investors refuse to pay a premium to call value. Consequently, it is far more likely that NLY-G would catch a bid (rise in price) than it is that NLY-F would catch a larger bid.

We like the valuation on NLY-G better here since it gives us more potential for price gains and materially less call risk. On Friday, just before the close, we traded our large position in NLY-F for a large position in NLY-G. (Selling NLY-F to fund a purchase of NLY-G)

We had built the position in NLY-F in two batches, one was purchased nearly a year ago and the rest were purchased from summer 2018 through winter 2018:

Source: The REIT Forum

Annaly Capital Management’s preferred shares have carried dramatically less volatility than the common stock. Despite the lower volatility, they have been just as effective at building shareholder wealth. The following chart demonstrates how much money would’ve needed to be invested in NLY or NLY-D over the last several years to reach $1000:

Source: The REIT Forum

We used NLY-D because it has existed much longer than NLY-F or NLY-G.

PREIT preferred shares

Last week we wrote that PEI-B and PEI-C (NYSE:PEI.PC) were the clear winners of the bunch (offering better risk/reward). During the week, we saw a large rally in the preferred shares and PEI-D (NYSE:PEI.PD) soared higher along with PEI-B.

Shares moved above $18.00 and we closed our position in PEI-D. Click HERE for the trade alert (subscription to The REIT Forum required).

The results are shown in the image below:

The return was roughly 19%. Given PEI-D’s outperformance relative to other preferred shares and relative to the common shares, it looked like a wise time to take our gains. Shares had just rallied out of our strong-buy range and we look to lock in the gains whenever we see a sudden 20% jump in the value of our position.

In this case, the price chart for the PEI securities could be very helpful:

When we talk about the importance of “relative value”, this is a good example. PEI-D was a bit more expensive than the others heading into the week, but it proceeded to be one of the top performers at that time. We figured buyers would start shifting to alternative securities. Normally, the preferred shares and common have only modest correlation, but we’ve seen very high correlation the last several months. We also know that when preferred shares trade at a huge discount to call value, the correlation often increases materially. When we see those factors developing together, it creates a great opportunity to issue a trade alert.

As of the end of the week (1/21/2019), PEI-B and PEI-C are still much better deals. PEI-B offers 10.48% stripped yield and PEI-C offers a 10.57% stripped yield. While PEI-C also carries some call protection on the calendar, we don’t put much value in the call protection when shares are trading at $17.85 for PEI-B and $17.28 for PEI-C. By comparison, at $17.34, shares of PEI-D carry a stripped yield of 10.05%.

We see PEI-D as the weaker value. Investors using the PEI preferred shares should be choosing PEI-B or PEI-C. We would favor PEI-C slightly here. However, beware the weak liquidity. It can be a challenge to get in or out of positions.

AGNC preferred shares

There are many benefits to investing in AGNCB:

  1. Investors get a steady stripped yield over 7.7%.

  2. The share price will most likely stay between $24.85 and $25.70 for the vast majority of days (very low volatility).

  3. If investors get called, they earned a much better return than a savings account.

  4. If investors don’t get called and the market tanks, AGNCB will continue to pay its dividend, providing investors with a solid stream of cash flow. If the investor wants to continue holding, the cash flow continues. If they decide to reallocate, anything else they want to buy will most likely have fallen far more.

  5. AGNCB has excellent liquidity for a preferred share. The bid-ask spread is usually small and the volume is reasonably high. An investor could move $100,000 in AGNCB with little risk of moving the market.

We’ve had months where there were painfully few opportunities for investors to grab a very solid dividend yield with a risk-rating of 2 or below. Currently, we have a few great opportunities and AGNCB is one of them.

AI baby bond

AIC remains a top choice here. It is only $.24 into the buy range. By contrast, AI-B (NYSE:AI.PB) is AI’s preferred share and it offers a dramatically worse risk-reward profile.

Beware liquidity.

The liquidity is dreadful here. Traders who have free trades credited to their accounts can still trade here with low limit-buy orders and high limit-sell orders. Without free trades, getting executed for 1 to 5 shares is very annoying. The risk rating of 3 is a bit high for the buy-and-hold investor, but the maturity on these baby bonds (3/15/2025) ramps up the total return. Investors are expecting to get about $2.00 in capital gains by simply holding to maturity, though AI does take more risk than other mortgage REITs.

TWO preferred share

The risk rating for TWO preferred shares is 2.5:

However, their best-valued preferred share (NYSE:TWO.PE) currently carries a stripped yield of 8.06%. The current price of $23.40 is better call protection than having call protection on the calendar. If anyone wants to suggest they would be brokenhearted about earning 8.06% and then getting told they were being called for a capital gain of $1.60 on top of their yield, they aren’t seeing the big picture.

That’s nearly a year’s worth of dividends in capital gain if a call occurs. For these shares, a call is much less likely than for AGNCB.

Risks for preferred shares

Note: We monitor all of these risk factors

Some of these will apply to all manner of preferred shares, but we are going to narrow in on things that matter more to mortgage REITs.

  • Risk Factor - Default

This is rarely an issue but is arguably the biggest risk factor. Without this possibility, investors would simply aim for whatever had the highest yield. Most of these factors are extremely low probability, but we want to address them to help investors understand the full range of risk factors.

  • Risk Factor - Enron

The first way to buy a preferred share and end up with a huge loss is to simply get “Enron-ed”. No matter how hard you work on your due diligence, a complete accounting fraud is still difficult to detect without inside information. The REIT Forum combats these risk factors by investing in companies or preferred shares with high-quality accounting. We can identify which companies have higher or lower levels of Enron-risk.

  • Risk Factor - Credit Risk

Credit risk comes from investing in a mortgage REIT that holds a portfolio of very credit-sensitive assets. If a huge portion of those assets go bad, the company could go under. This is a case where losses in their assets could turn into losses for the investor. Due diligence should be a huge factor in assessing the level of risk here.

One example of this kind of risk comes from Apollo Commercial Real Estate Finance (ARI). If we hit a major recession and the value of the collateral tanked, investors would expect the loans to go bad and ARI could suffer horribly. That doesn’t mean there is anything fundamentally wrong with their company today.

  • Risk Factor - Spread Risk

Spread risk comes from the risk that a mortgage REIT’s assets and hedges won’t offset effectively and the equity value would be destroyed. When this happens the immediate impact is a large decline in book value per share, but theoretically, if it were bad enough, the common could be wiped out and the preferred could suffer material losses.

While we do see substantial risk to the value of portfolios, we don’t see much risk to the preferred shareholder from this factor. It could happen, but it would be a huge surprise.

  • Risk Factor - Duration Risk

This is the risk that the mortgage REIT is taking on too much duration exposure to try to pump up their net interest spread. In this scenario, a huge movement in rates going in the wrong direction could decimate the value of the portfolio.

While we do see substantial risk to the value of portfolios, we don’t see much risk to the preferred shareholder from this factor. It could happen, but it would be a huge surprise.

  • Risk Factor - Yield Movements

This is not the same as the risk of a default caused by rapid movements in yields. This is the risk that even though the mREIT remains fine, a substantial movement higher in Treasury yields and bond yields leads to a corresponding movement in preferred share yields. In that case, the fair value could decline. As of my writing this, the yield spread between Treasuries and the preferred shares remains large by long-term historical standards, even if it seems low relative to the last couple years.

Rapid movements in interest rates will often have a temporary negative impact on preferred share prices. If rates go back to moving gradually, the preferred shares usually bounce back.

  • Risk Factor - Call Risk

The risk of a call creates a soft ceiling on prices. Sometimes transactions will go materially above that on a price spike, but generally speaking, the potential for a call limits the appreciation preferred shares can enjoy.

There are two major forms of protection from call risk. One is “calendar protection”. This applies when the shares are not eligible for calling yet. The second is “price protection”. This is where you buy the security at a material discount to the call value. That way, if a call happens while you’re still holding the shares, it creates a capital gain on the position rather than a loss.

Allow us to point out that companies very rarely call securities trading under call value. They can simply buy those securities back in the open market. There is no reason for them to issue a call and pay a premium to the market price. This is an area many investors struggle with. Companies rarely call their preferred shares unless they are trading at a premium. Usually, they would do it when they think they can issue new shares at a materially lower rate.

Investors wanting to see examples of this can look at Realty Income Corporation (O), National Retail Properties (NNN), or Gladstone Commercial Corporation (GOOD). These are all equity REITs, but they each have experience calling preferred shares while issuing new ones at lower rates.

  • Risk Factor – Keyboard to Chair

A poor decision emanating from somewhere between the keyboard and the chair can still lead an investor to buy high and sell low. This is different from selling at low price with a tiny loss because the fundamentals changed. That would fall under factors like “Credit risk”. This is simply the risk of a poor decision.

  • Which Factors Can Investors Influence?

Pretty much everything else here falls under doing proper due diligence. The risks cannot be completely wiped out, but they can be minimized by doing the necessary research before the first transaction.

Supplementing ETFs

Many investors may want to invest in high yield ETFs such as the Vanguard High Dividend Yield ETF (VYM). While the expense ratio is low at .08%, the yield only comes in at 3.25%.

Investors looking to mortgage REITs or preferred shares often look to the iShares Mortgage Real Estate Capped ETF (REM), the VanEck Vectors Mortgage REIT Income ETF (MORT), the iShares U.S. Preferred Stock ETF (PFF), and the Invesco Preferred Portfolio ETF (PGX). While these yields range up to near 10% for the highest one, the expense ratios range from 0.41% for MORT to 0.52% for PGX. The high expense ratios take a significant amount of your returns over time. Further, the two mortgage REIT ETFs have significantly more volatility than investing in preferred shares.

While we do believe some investors should stick to ETFs, the majority of income investors should look to supplement their income with individual preferred shares. We believe investors should assess their risk tolerance and do due diligence on individual investments. That can be done easier with individual preferred shares relative to a preferred share ETF. Further, individual investments won’t carry the high expense ratio.

Does the strategy work?

We invest almost entirely in REITs and preferred shares. Preferred shares have been a major source of our returns. We beat the largest REIT ETF, the largest preferred share ETF, and the market (SPY).

So what drove the returns?

We run a significant portion of the portfolio through preferred shares. We highlight opportunities for both buy-and-hold investors and for traders. When we're able to pull off the dividend captures, it often delivers returns over 1.5% in a month, which compounds out to support a return around 20% on the year.

We aim to get between 7% to 8% returns with relatively low risk year over year. To get double-digit returns in the preferred share space with exceptionally low credit risk, some trading is necessary. To earn around 7% to 8% per year, buying and holding is perfectly viable.

Final thoughts and the importance of diversification

While most of our coverage is on REITs with far less than average risk, The REIT Forum still recommends diversifying. We invest the substantial majority of our portfolio in REITs and preferred shares. We suggest that investors choose a maximum allocation using our risk ratings combined with their risk tolerance. Each of our risk ratings connects with a suggested maximum allocation. The maximum allocations generally range from 1% for higher risk options to 6% for our lowest risk choices. By diversifying among these choices, investors can build a portfolio with a less volatile value and more consistent dividend growth. All our positions are shared with our members and our latest picks for preferred shares are included in a recent article: “Preferred Shares Week 135”.

Ratings

Disclosure: I am/we are long AGNCB, AIC, ARI-C, NLY-G, NLY-C, TWO-E. 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.