Watch Out For Lower Reset Yields In Preferreds

Summary

• Lower reset yields add to a long list of concerns for preferred stock investors.
• Market expectations of lower reset yields are a result of sharply lower short-term rates.
• Investors should focus on the available relative value opportunities depending on their view of short-term rates and likelihood of calls.
• This idea was discussed in more depth with members of my private investing community, Systematic Income. Get started today »

As if preferred investors had nothing to worry about in the current market environment. A debacle in the energy markets, sharp unwinds in mortgage REIT collateral, depressed earnings in hospitality REITs and the list goes on and on. In this article, we take a look at another concern - the issue of lower reset yields - or the expected drop in yield of fixed-to-float preferred stocks once the stock moves past its first call date. We calculate that at current market expectations, the average fixed-to-float stock will see its yield drop by about 2%, potentially taking away a big chunk of the existing distribution.

Our main takeaway is that investors should take a closer look at relative value opportunities on offer within the different series of the same issuer depending on their view of short-term rates and likelihood of calls.

Why Worry About Reset Yields?

The drop in expected coupons and the lower likelihood of calls are the chief reasons why investors should worry about reset yields. Preferred stock prices are still relatively depressed despite a sharp rally from the drawdown trough last month. With the median clean price trading around 23 from above 25 prior to the drawdown, the market is sending a message that preferred stocks, by and large, are unlikely to refinance existing issues. This means that once a fixed-to-float stock moves past its first call date, the coupon will switch to a floating rate.

Source: Systematic Income Service

This coupon switch to a floating rate would not be a serious problem in a normal market environment. The trouble is we are not living in a normal market environment. Short-term rates, which are the base rates for preferred stock floating-rate coupons, have collapsed. This means that on average a fixed-to-float stock will see its yield drop about 2% based on current Libor forwards. Of course, by the time many of these stocks float, Libor will no longer exist, but the coupon economics will be maintained.

What, Me Worry?

Just as there are reasons to worry about lower reset yields, there are also reasons for some investors not to worry about them. One reason not to worry about lower reset yields is if you think short-term rates are going up. While most market participants believe short-term rates are likely to stay low for an extended period of time, they could very well be wrong. So, if your view is that rates are going to go up, say, because of an increase in deficits, then you might actually welcome floating-rate distributions.

Another reason you might not worry about reset yields is if you think the fixed-to-float stocks you are holding are going to get called. Stocks in some of the stronger sectors like banks and CEFs are trading above their liquidation preference and are more likely to get called. Of course, this poses the obvious question of having to reinvest your principal, but that's a battle for another day.

A third reason you might not worry about reset yields is if you think the stocks are pretty much fairly priced at the current moment. What this implies is that while the reset yield may very well be lower than the current fixed-coupon stripped yield, like a balanced see-saw, the current stripped yield is artificially boosted due to the likelihood of lower future floating-rate yields. This is less of a comfort for investors relying on a fixed income from their portfolio, but those investors are more likely to be in fixed-coupon stocks anyway.

Fourthly, and thankfully, the reset yield issue does not affect all preferreds. By our count only about 20% of the retail preferreds population is fixed-to-float, so even a portfolio picked by throws of darts will have a relatively small proportion of stocks with this issue.

Finally, some long-term investors may take the view that while short-term rates are likely to stay low over the next few years, the market will begin to stabilize over the next decade. This means that preferred stock returns over the coming decade will consist not only of the floating-rate coupons but also of the pull-to-par element. And because fixed-to-float stocks will tend to trade at lower prices than fixed-rate stocks, all else equal, given their lower reset yields, the pull-to-par element will be that much stronger for floating-rate stocks.

To illustrate this dynamic, let's take a look at the Morgan Stanley preferreds. The Morgan Stanley Floating Rate Dep Shares Series A (MS.PA) is a floating-rate stock with a 4% floor which is trading 3-7% below prices of the other series. Because MS-A is trading so much below "par", its upside in the scenario that all the series get called is much higher. We quantify this potential upside using forward yield - a metric that we calculate daily on our service. It is simply the all-in return of the stock if it gets called on a given date over the next decade. The chart below shows that despite its lower stripped yield, MS.PA boasts higher returns in the scenario all the series get called at any point in the next decade.

Source: Systematic Income Service

Look Out Below

Before we take a look at the results, let's break down the mechanics of the reset yield issue. We use the Annaly Series F (NLY.PF) for no reason than its call date is relatively close in September 2022 which makes it easier to think about short-term rates. The stock has a fixed coupon of 6.95% until that date and a coupon of 3M Libor + 4.993% after its call date.

To figure out what the coupon will be after the reset, we need to know what 3M Libor forwards are right now. 3M Libor forwards are the future 3M Libor rates implied by the current term structure of interest rate swaps which we show in the chart below. The chart shows a sharp drop and then steady growth. The drop has to do with the fact that the belly of the swap curve is below current short-term rates. This has largely to do with the fact that there is a large spot Libor/SOFR basis, although it has come down significantly as the market stress has begun to dissipate. As the market continues to normalize, Libor should move lower towards Fed Funds. The steady rise in Libor forwards after about 2021 has to do with the upward-sloping shape of the interest rate curve across those tenors. It would be technically incorrect to say that "the market expects higher short-term rates" because there are more than market expectations baked into the interest rate term structure such as the inflation and term risk premia. That said, the shape of this curve largely jives with what many commentators think should happen in short-term rates across the next decade.

Source: ADS Analytics

So, to get back to NLY.PF, the clean price of the stock is currently 20.72 which, at its fixed coupon of 6.95%, translates to a 8.39% stripped yield. When the stock floats, its coupon is expected to become 5.36% which is the sum of 0.37% Libor forward in September 2022 and the spread of 4.993%. A coupon of 5.36% at the current clean price of 20.72% translates to a 6.47% stripped yield. The difference between the 8.39% current stripped yield and the 6.47% reset yield is 1.92% which we call the reset yield jump. And although Libor forwards are expected to move higher gradually over the next decade, the rise is expected to be gradual.

A Bigger Picture

In the chart below, we plot stocks with reset yield jumps below -1.5% to keep the chart readable. Within our preferreds population, we calculate that all reset yield jumps are negative and roughly -2% on average. Why is this the case? This has largely to do with the fact that when these stocks were issued, Libor rates were well above current levels. The spreads above Libor were calculated to roughly equal the then fixed coupons. However, now that short-term rates have dropped sharply, the future floating-rate coupon levels have fallen as well.

Source: Systematic Income Service

Of course, the reset yield jump is not the only thing that matters - the proximity to the jump is important as well. We combine the two metrics in the chart below, showing stocks with less than 4 years to first call date.

Source: Systematic Income Service

Investor Takeaways

What options are available to those investors concerned with large negative reset yield jumps?

Normally, we would recommend investors to tilt towards stocks that give issuers certain additional rights such as an ability to put the stock back to the issuer, stocks with fixed-rate floors or stocks with step-ups. Unfortunately, these options are not available for fixed-to-float stocks.

One option for investors is to tilt towards sophisticated issuers such as banks for their fixed-to-float exposure as these issuers are more likely to hedge out their floating-rate exposure and focus instead on credit spreads as the basis of their call decisions. This means they are less likely to call fixed-rate stocks over floating-rate stocks when rates are low.

Another option, and our main takeaway, is for investors is to take advantage of any relative value opportunities among the different series of the same issuer. We show the four different series of Annaly preferreds in the table below. For the three fixed-to-floating stocks, the reset yield varies hugely from 5.65% to 6.70% which is a much larger range than we would expect. Current stripped yield, on the other hand, is in a much more narrow range of 7.96%-8.39%. This suggests to us that the market may be pricing these stocks on a stripped yield basis and ignoring reset yields, at least for this issuer.

Source: Systematic Income Service

Among the three fixed-to-float series, Series F (NLY.PF) and Series I (NLY.PI) look more attractive relative to Series G (NLY.PG). Investors who don't think any of these series are likely to get called in the medium term and rates are going to stay low for a long while may be better off with Series D (NLY.PD) which would have a higher stripped yield in that scenario. On the other hand, investors who think that these stocks are likely to get called may find fixed-to-float series preferrable to NLY.PD as these stocks should experience a stronger pull-to-par. We show this using our forward call yield metric below.

Source: Systematic Income Service

Conclusion

The expectation of lower reset yields adds to an already long list of investor concerns in the preferreds market. Short-term rates are expected to stay low for many years which may result in a drop in coupons of fixed-to-float stocks as they move past their first call date. Our takeaway for investors is to focus on relative value opportunities within different issuer series depending on their view of the path of short-term rates as well as likelihood of calls.

Disclosure: I am/we are long NLY.PD, MS.PA. 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.