Buy Rated Preferreds (And Market Update)

Summary

• Preferreds have continued powering higher on the back of lower volatility and spread compression.
• Few opportunities exist among IG preferreds but there are still some beaten-down high yield preferreds with catch-up potential.
• Preferred investments should balance credit, rate, and call risk with upside potential.
• We explore opportunities in a number of prefs and baby bonds.
• Looking for a helping hand in the market? Members of Yield Hunting: Alt Inc Opps get exclusive ideas and guidance to navigate any climate. Get started today »

(This report was first issued to members of Yield Hunting and in Landlord Investor's model portfolio on December 24th, 2020. All data herein is from that date.)

This is a guest post by Landlord Investor.

The preferreds market (PFF) has continued marching higher by 1.62% over the past month, nearly matching the performance of high-yield bonds while significantly outperforming IG bonds. PFF is a little more than half investment grade. This impressive performance (on an annualized basis) comes despite weakness in the treasury market (TLT) which lost 2.35% over the past month due to higher rates. That indicates that preferreds performance is the result of spread compression caused by low realized volatility.

The strong preferreds market has led to a resumption of the high level of calls that was experienced just prior to the pandemic. Call activity could eclipse that level going forward as rates are lower and the economy is forecast to grow at a rapid clip in 2021.

Source

While call risk is real, it's important not to overestimate the risk either. Many investors avoid all callable securities above par even if they are unlikely to be called. Only a small fraction of the hundreds of preferreds and baby bonds get called each month. Unless the issuer is a huge bank like JPMorgan (JPM) or highly rated with a track record of aggressive call activity like Public Storage (PSA), it's unlikely an issuer calls a preferred unless they can save at least 80-100 bps by refinancing it into a lower yielding preferred. Refinance costs are typically 300+ bps. Many good risk/reward opportunities exist with preferreds that could be refinanced 25-65 bps lower but trade only a small amount over stripped par.

Investors should balance five factors when buying prefs/BBs:

• Credit Risk - The risk an issuer goes

Analyst’s Disclosure:I am/we are long LANDLORD IS LONG ALL OF THESE NAMES. 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.