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Earlier this week, we wrote an article on 5 high yields in the preferred share space. We'd like to dig a little deeper into why preferred shares should be attractive to investors and then some actionable options today.
We believe directly investing in individual preferred shares is dramatically superior to just using the preferred share ETFs. The ETFs carry pretty hefty expense ratios. That means an individual investor could get a comparable yield with a much safer security because they wouldn't need to pay the expense ratio. In short, they get a higher yield with the same risk.
The iShares U.S. Preferred Stock ETF (PFF) and similar ETFs have a place. They work for the investor willing to sacrifice part of their returns to avoid picking shares. For those wanting to earn a greater return, the expense ratio is a great thing to cut.
Further, there is an added benefit here because the individual investor can watch for the right entry prices and use the weaker liquidity to their advantage (limit-buy orders and limit-sell orders, never a market order).
We are always happy to have our preferred share investment performance compared to PFF because we beat it so thoroughly by taking advantage of these simple factors.
Our picks include some preferred shares. We've found preferred shares provide an excellent opportunity for investors to get a high yield with lower volatility. We cover preferred shares frequently and some of today's picks come from our latest article for subscribers: Preferred Shares Week 136."
Here are some rating changes:
Source: The REIT Forum
Why invest in the preferred share over common stock
We will be using AGNC Investment Corp. (AGNC) as an example.
If AGNC reduced their dividend by 25%, there would be no impact on their preferred share (AGNCB). If book value declined by 25% (which would be dreadful for the common), there would be no impact on AGNCB.
AGNCB is a lower yield with dramatically lower risk. Think of it as about two-thirds of the yield for less than a third of the risk.
Long term the book value tends to trend lower, so high dividends are often partially offset by lower book value. There is no decline in call value or in dividend amount for AGNCB.
Diversification in preferred shares
We cover over 50 preferred shares, but rarely have positions in more than 15 at a time. We usually have our top choices heavily overweighted as well.
We believe the amount that investors should invest in preferred shares is not a specific %. Our allocation in preferred shares can swing in either direction for a few reasons. When investors are confident in their common stock investments, they are less likely to invest a significant amount into preferred shares. When investors are worried about common stocks, they may allocate more to preferred shares. We believe that it's important to look at:
The current economic environment
Personal investment style
Putting preferred shares in the portfolio
Imagine 32% of an income portfolio in preferred shares with allocations of 4%. We are talking about 8 positions. We provide extensive research on the shares along with buy alerts to help investors reduce the time involved in identifying the right shares and prices.
I agree with the idea investors can only track so many securities effectively. Having 18 to 20 preferred shares within their portfolio is on the high side even for an analyst.
We have 6 preferred share positions which are greater than 2% and a handful of smaller positions.
For a million dollar portfolio, 4% would mean $40,000, which would mean roughly 1,600 shares if they traded in the ballpark of $25.
Note: For investors who aren't used to preferred shares, the vast majority of them will trade between $23.00 and $27.00. That doesn't mean every single share, but the vast majority.
For some preferred shares getting in and out of a 1,600 share position is difficult, but for shares such as NLY-G (NLY.PG) from Annaly (NLY) and AGNCB, two of our larger positions, the volume is sufficient. Earlier this week, AGNCB traded 52,969 shares and NLY-G traded 71,672 shares in 1 day. For shares where normal trading volume might be under 2,000 shares in a day, investors need to be patient and have their lowball limit-buy orders set. Having an analyst or some real-time spreadsheets helping to identify which shares are going on sale makes it easier.
I agree wholeheartedly with limiting risk. We prefer to overweight shares with lower risk ratings and we assign the risk ratings ourselves. There aren't many credit rating agencies covering these REITs, but we've covered the common shares and built up the knowledge necessary to evaluate the risk levels. We also benefit enormously from running a subscription research service covering preferred shares for over 700 members. One individual retiree would never have the time to do this manner of research for themselves. One more-than-full-time analyst plus an apprentice shouldn't have much difficulty doing it.
Many of our 700 subscribers are B&H investors.
They use our research to screen for low-risk shares and then to watch for buy alerts so they can lock in higher yields. We hit NLY-G with a huge buy rating last week when shares closed around $23.03. As you know, for B&H investors getting the higher yield without accepting higher risk leads to a much better risk-reward.
I think REIT preferred shares can be an excellent part of a B&H strategy. If investors intend to hold for a period measured in years, then I think avoiding the expense ratio of the ETFs is a huge advantage. It allows the investor to either buy shares with lower yields (and higher credit quality, even if unrated) or to capture the higher yield for themselves. The normal expense ratios for preferred share ETFs are still painfully high because there hasn't been as much widespread competition as there has been for "whole market" ETFs or "S&P 500" ETFs.
There is no need for buy-and-hold investors to trade out as often as we do. They can simply use the buy ratings to know where to start new positions. We do rigorous research to find the safest securities for risk-averse investors. That is the primary reason we have risk ratings - so investors can invest where they are comfortable.
Ideas for buy-and-hold investors
We have positions we hold for long periods of time. We recommend several positions as being viable for buy-and-hold investors.
For the B&H crowd, we still like NLY-C (NLY.PC) a great deal. Currently, the yield to call is about 6.95% thanks to the dividend accrual. That's far from a bad deal. However, shares might not get called. NLY would want to call NLY-C (7.63% coupon rate) if they could issue NLY-G (NLY.PG) (6.5% coupon rate) to replace it. However, NLY-G is trading at $23.65, not even close to $25.00. If they were issuing NLY-G at $23.65, the prospect of calling NLY-C wouldn't be near so attractive.
If NLY-C doesn't get called, investors are sitting on a 7.67% stripped yield from a risk-rating 1 preferred share. That is a very attractive scenario. Getting 7.67% annually on minimal risk is excellent.
A recent chart for NLY-C is shown below:
Source: StreetSmart Edge
Credit for noticing goes to a subscriber who will go unnamed here, who called it out earlier this week.
Volume isn't extremely high, but we've been able to get execution at $25.15 without a problem. We think a larger seller might be hiding the size of their position, so at $25.15 or $25.16, a buyer may be able to acquire quite a large volume of shares. We provided a buy alert in real time:
NLY-G & NLY-F
NLY-F (NLY.PF) & NLY-G (Risk 1) both rallied nicely. NLY-G kicked it up a notch though with a fairly massive $.62 gain. That brings NLY-F down to a hold and NLY-G down to a regular buy rating.
Getting to our high level of annual returns with low volatility requires a bit of trading. To maximize annual returns, we advocate taking advantage of the poor liquidity within preferred shares.
We utilize the shares trading within a normal range combined with most investors ignoring "short-term fluctuations" to play the price movements for much higher annualized rates of return. There is nothing wrong with buying high-quality preferred shares and holding onto them for income. It's one of two very viable ways to earn a significant amount of money in the sector (B&H and trading).
We're trading our preferred share positions to capitalize on the poor liquidity. As securities become in favor or out of favor, we rotate through to capture the ones that are undervalued. That allows us to consistently act on our ratings (requires having cash available) and to maximize our annual returns. For the buy-and-hold investor, it demonstrates how successfully we've found the ideal entry points. Even from a buy-and-hold perspective, getting in at a price that is 2% lower means getting about 2% more shares and thus 2% more income.
We're making a trade between PREIT's (PEI) common shares and PEI-C (PEI.PC). The C series of preferred shares has recently underperformed by a large degree. It carries a lower yield than PEI common shares and has less upside, but it also carries materially less risk.
This is one of those times where we are eating a loss so we can swap into a similar security which has underperformed.
The following chart demonstrates:
Where we had our large purchase on PEI
Where we bought PEI-D (PEI.PD)
Where we took gains on PEI-D
Where we are swapping PEI for PEI-C
For PEI, closed shares between $7.53 and $7.54.
For PEI-C, bought shares at $17.48.
We are still bullish on PEI and PEI-C. However, we swapped our position because of the very compelling risk-reward profile on PEI-C.
We highlighted (NYMTN) in Preferred Shares Week 134 as a share where we wanted to take our profits (selling NYMTN) to fund buying shares of AGNCB. Our attempt to sell NYMTN didn't go through as we wanted to move a sizeable amount of shares and our limit-sell price was slightly too high. Throughout the week NYMTN dipped back by $.47, which brought it back into our buy range and made it appealing for traders again.
The shares carry an exceptionally high yield, have call protection on the calendar, a large discount to call value and a floating rate when call protection ends. The only downside is the high risk rating of 4.
Remember that risk ratings of 4 or above are only meant for trading.
Now NYMTN is $.50 inside the buy range instead of $.47. Seeing the share price for PFF rally over the last week is a positive sign here as well. When investors are hunting for yield, these shares can catch a solid bid.
NYMTN is a buy under $23.00.
ARR-B (ARR.PB) from ARMOUR Residential REIT (ARR) (Risk 4) rallied into a sell and is now trading around its normal (overvalued) level. Investors reaching for yield in a trading opportunity should be looking for NYMTN instead (8.96% stripped yield and far more price upside). Investors reaching for yield in a buy-and-hold position shouldn't be reaching for yield at all. At moderately lower yields there are far safer securities. ARR-B has an 8.04% stripped yield for a risk rating of 4. CMO-E (CMO.PE) from Capstead Mortgage Corporation (CMO) has a 7.79% stripped yield for a risk rating of 2.
Don't reach for an extra .25% of yield.
Preferred shares are less volatile than common shares
Preferred shares rarely climb or fall as much as common shares. That can be a concern for companies where a substantial appreciation over the next five years is a strong possibility. For the mortgage REITs, such capital appreciation is extremely rare. The return is mostly the dividend minus a decrease in price. Of course, a few trading opportunities still exist in the common. For long term investments, the safety of the preferred dominates on a risk-adjusted basis.
Mortgage REIT preferred shares
Mortgage REIT preferred shares generally aren't covered by any credit rating agencies. That's one of the reasons they carry higher yields. For the analyst who can evaluate the risks themselves, it is an opportunity to generate higher returns in exchange for doing the work of the credit rating agencies.
Explaining worst cash to call
We've had some questions on our worst-cash-to-call metric, so we would like to break it down.
It's an estimate of the net amount the investor would get back if shares were called (including all distributions such as dividends).
For example, if the latest price is $25.20 for a preferred share but our math suggests an immediate call would give investors about $25.40, then worst-cash-to-call is $.20. On the other hand, if shares were $25.50, the worst-cash-to-call would drop to negative $.10.
It can help investors avoid making poor decisions based on "yield to call" values in the instance where yield to call gives an absurd result.
For example, let's say two preferred shares are both trading for $24.75. One has 6 months of call protection and the other has only 1 month of call protection. There is zero other difference between the two hypothetical shares. An investor who spends too much time looking at "yield to call" would incorrectly believe that the share without call protection was superior. If an investor wants to be callable at any time, they can always reach out to a family member and give that person the right to buy their shares for $25.00 at any point.
As silly as it sounds, I've occasionally heard investors indicate that they are choosing a given share (among two very comparable shares) because of the higher yield to call.
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 and the largest preferred share ETF.
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 are perfectly viable.
Investors looking for strong risk-adjusted returns should be including preferred shares in their portfolio. The preferred shares offer high levels of income and the preferred dividend has complete priority over the common dividend. By picking individual preferred shares rather than using an ETF, the investor can avoid the expense ratio and capitalize on shares which are noticeably cheaper than their peers.
The combination of no expense ratio and better entry prices allows the investor to generate more income without taking extra risk. Currently, NLY-G and NYMTN are both in the buy range. NLY-G is a better fit for buy-and-hold investors who want a stable source of income with lower risk. NYMTN is more useful for investors who are comfortable taking on significantly higher risk or trading preferred shares.
We find ARR-B is significantly less appealing than NYMTN or CMO-E. Shares of CMO-E had a much lower risk rating to offset the lower yield at $24.23. Shares of NYMTN carried the same risk rating but had a much higher yield and substantial call protection.
The REIT Forum is the #1 rated service on Seeking Alpha. We focus primarily on defensive investments with high growth potential. It is our objective to find quality investments at a discount, along with trading opportunities for the more active investors. Most of our research is on companies that are excellent investments over the long term.
Disclosure: I am/we are long AGNCB, CMO-E, NLY-C, NLY-G, NYMTN, PEI-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.