Wells Fargo Series L Preferred: Still Bullish

Summary

• We revisit the investment case for WFC.PL - a bank preferred we liked for its higher-quality, above-average yield and long duration.
• The stock has outperformed the broader banks sector, in line with the BBB-rated segment of bank preferreds.
• We, however, had expected an outperformance, particularly in a period of lower risk-free rates.
• We remain bullish as we expect credit spreads to tighten faster than for rates to move back up; however, in case of further weakness, the stock should still perform relatively well.
• This idea was discussed in more depth with members of my private investing community, Systematic Income. Get started today »

A few months ago, we discussed the Wells Fargo & Co. 7.50% Series L Preferred (WFC.PL) which we liked for its longer-duration and higher-quality features relative to the broader bank's sector. Given the volatility we have seen over the last few weeks, we thought we would revisit the investment case for the stock.

Our takeaway is that while the stock performed in line with the rest of the BBB-rated bank's sector, it did not outperform, despite its longer duration and a sharp drop in risk-free rates. This underperformance versus our expectations leaves us bullish for a few reasons. Firstly, the stock still offers a yield well above the sector average, despite its above-average rating. Secondly, in the more likely scenarios of 1) normalization and 2) further stress, we would expect the stock to perform well as in the former case credit spreads are likely to rally more than interest rates will rise and in the latter, we would tilt towards longer-duration and higher-quality assets than the sector average. The risk to the stock is a period of higher interest rates and wide credit spreads, a scenario we view as the least likely.

Sector Performance By Quality

Let's take a look how the bank's sector performance looks across the quality spectrum. We proxy quality by the S&P credit rating and plot total returns since the start of the drawdown in the chart below. The vast majority of the around 135 stocks cluster between single-B and triple-B ratings with a bunch not rated, called "NR" in the chart.

If we group the stocks by rating (e.g. BBB-, BBB, BBB+ go into the rating shown as BBB in the chart, etc.), avoiding a few stocks with very poor liquidity, then we see a couple of interesting things. First, as we would expect, the highest rated BBB bucket has held up the best in the current drawdown.

Interestingly, there is not much differentiation between the B and BB-rated buckets. This can be because the single-B bucket is quite small and so may be unrepresentative. Or it could be because investors do not differentiate much between ratings in the high-yield category.

Another interesting aspect of the chart is that the fairly large not-rated bucket has held up very well - closer to the BBB bucket than the high-yield buckets. This suggests that investors may be avoiding the not-rated bucket despite its apparently lower volatility, at least in the bank's sector.

Source: ADS Analytics LLC, Tiingo

The takeaway from this chart is the entirely unsurprising conclusion that focusing on quality worked as expected during a period of market weakness.

Sector Performance By Callability

Let's turn to the performance of callable stocks versus the two-sector perpetual stocks. Our initial expectation was that because the perpetual stocks had a much longer duration due to the lack of the call feature, they would outperform in a period of market weakness.

The chart below shows the returns of the two perpetual bank stocks against the BBB-rated bucket of the bank's sector. The two stocks performed largely in line with the bucket. As we expected a much stronger performance from these two stocks, this did not quite pan out as we had expected.

Source: ADS Analytics LLC, Tiingo

Does A Long Position Still Make Sense?

So, what to do now with WFC.PL? In our view, the fact that the stock did not outperform the higher-quality part of the bank's sector offers an opportunity. On a yield basis, the stock still offers a yield pick-up of 1.4% to the average bank preferreds YTW and a pick-up of 0.53% to the sector median YTW which is plotted below.

Source: Systematic Income Preferreds Investor Tool

If we plot the YTW metrics (we set the YTW of the WFC.PL to the stripped yield, ignoring the small conversion risk) for both the stock and the bank's sector, we can see a sharp convergence over the past few weeks. Why has the yield differential between WFC.PL and the bank's sector collapse? We can see from the chart that the yield of WFC.PL has not changed very much and that it was the sector yield that jumped up. This has largely to do with the fact that many bank preferreds went from a negative YTC to a positive one. In this case, the positive YTC, though it can be low, is far from a "worst-case scenario" as it would provide an immediate windfall to the holder. In this case, the YTW switches over to the stripped yield which can result in a big jump from a negative number to a mid-single-digit number.

Source: Systematic Income Preferreds Investor Tool

Given the stock's long duration, an important question is what could happen if interest rates move back up? Is the stock set-up for a big drop? In our view, not really - for two reasons.

First, the yield spread to Treasuries of the stock has widened around 0.9% which we expect to cushion any moves higher in rates (the long bond yield dropped 0.76% during the drawdown period).

Source: Systematic Income Preferreds Investor Tool

Secondly, while we would expect credit spreads to tighten back to their pre-drawdown levels, we think it is less likely for risk-free rates to move all the way back to their pre-drawdown levels, largely due to the recent cuts made by the Fed.

Thirdly, though it is not our base case, we should not dismiss the possibility that interest rates retest their historic lows if the coronavirus pandemic gets out of hand. In this case, we would be more comfortable holding a security that is both higher-quality and longer-duration than the average preferred.

The risk for the stock is if interest rates move up sharply without a tightening in credit spreads. We view this scenario as fairly unlikely.

Conclusion

We remain bullish on WFC.PL as the stock has underperformed our expectations and performed in line with the rest of the higher-quality bucket of the bank's sector despite a sharp rally in risk-free rates. The stock continues to offer a yield at the higher-end of the bank's sector, despite its higher than average rating. In a normalization scenario, we expect credit spreads to tighten quicker than for rates to move back up which should support the stock; however, even if rates and spreads move back to where they were pre-drawdown, we expect the stock to have a positive return.

Analyst’s Disclosure: I am/we are long WFC.PL. 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.

Comments

[Vlae Kershner]

I don’t get why you say perpetual stocks should overperform in a time of market weakness. It seems to me the callable issues would do better because call risk diminishes as the price goes down, whereas WFC-L has about the same call/conversion risk it always did (very low).

[ADS Analytics]

Because when market is weak, rates typically go down. Perpetual stocks have longer duration hence they should outperform, all else equal. Call risk does go down for callable stocks because credit spreads blow up and prices go down often below the strike.

The key point is that the duration of a callable bond is still going to be below that of a similar non-callable bond. Relatively speaking the duration of a callable bond will increase when credit spreads blow up but it will never exceed that of a non-callable bond, pretty much by definition.
ADS

[Vlae Kershner]

I get what you're saying, but overall interest rates are a minor factor in a panic compared to worries about solvency. Look what happened to WFC-L in 2009.

[ADS Analytics]

It's true that credit spreads have moved a lot more than interest rates but at the same time we can envision a scenario where credit spreads tighten back down while rates remain lower. Ultimately, if rates go up both callables and non-callables get hit while, if rates go down, (let's keep everything else the same) then perps should perform better. It seems like perpetuals give you that additional optionality of outperformance.

Your point about 2009 is beside the point ie if everything goes to zero then yes I agree holding perps over callables doesn't matter but there are clearly scenarios where perps are better than callables. I don't see scenarios where callables are better than perps unless callables pay you a higher yield which they really don't in this case (WFC-Q does have a higher yield right now but if things recover it's going to get called away whereas WFC-L will not).
ADS

[nrg9]

25 is where this fraudulent Co. looks attractive

[bry899]

I like the WFC.PL, and currently own it, I bought it closer to its share price now, which is currently yielding 5%. But the common shares which I am purchasing are yielding 6.25% currently. The only downside is a possible future dividend cut for the common share.

[glssmrbl]

@bry899

Are you saying the common shares offer better total return?

[coastalcruiser]

My greatest concern with WFC as well as their preferred stock is the payout ratio
It is 1837% THIS IS THE HIGHEST I have ever seen. So the Question of the day is, "Is this normal?"

[aj485]

@coastalcruiser The answer to your 'Question of the day' is: No, it's not normal. But it's also not normal to calculate a dividend payout ratio on a preferred stock. Dividend payout ratios are generally calculated on common stock, as annual dividends per common share/earnings per common share. For WFC in 2019, that was $1.92/$4.08 = 47.05%

I suppose if you wanted to calculate a payout ratio for a preferred stock, you could, but you'd have to calculate the earnings per preferred share for that stock first. Based on the income statement in the WFC 2019 10-K www08.wellsfargomedia.com/... WFC net income was $19,549MM for 2019, and in Note 20 of the 10-K, it says that there were 4.025MM "authorized and designated" shares of WFC-L. That means the earnings per share of WFC-L were $18,984.39 That means that the calculated payout ratio is $75/$18,984.39 = 0.395%

Feel better now?