Interest Rate Protection From Allstate Baby Bonds With A 16% Potential Return

Sep. 28, 2022 12:26 PM ETThe Allstate Corporation (ALL), ALL.PB67 Comments

Summary

  • We are in the search of fixed income instruments that will save us from interest rate risk.
  • Floating rate baby bonds that trade bellow par are clearly mispriced, especially the high credit quality one.
  • We look at the entire fixed income world to present a simple and yet sophisticated idea that we believe is a shelter in the rising rates environment we are in.
  • Looking for a helping hand in the market? Members of Trade With Beta get exclusive ideas and guidance to navigate any climate. Learn More »

The article was first published to members of my service on September 26, 2022.

Umbrella to protect a roll of banknotes

malerapaso

In all our future articles we will have a small intro presenting the yields of various asset classes so that the reader gets an idea of what is normal in the current environment. This includes the treasury yield curve, mortgage rates, corporate bonds, fixed-rate preferred stocks, and a number of instruments we find interesting and representative at the moment. We call this "the big picture". After the big picture, we present our income idea in the shortest way possible hopefully without any fluff.

The Big Picture

US Treasury

As we all know in the last weeks the US Treasury yields jumped to their highest levels in the last decade and the curve is now inverted:

US Treasury Yields

US Treasury Yields (Investing.com)

US Yield Curve

US Yield Curve (Fed Data)

Fed Funds Rate

On September 21st last week The Federal Reserve raised rates by 0.75% and brought the benchmark to 3.25%. Fed officials have signaled their intention to keep increasing interest rates as much as needed to fight inflation. The market expectation can be seen below:

Fed Funds Rate Expectation

Fed Funds Rate Expectation (Cmegroup.com)

LIBOR

The London Interbank Offered Rate(LIBOR) is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans. The current 3-month LIBOR Rate is 3.60%, while at the beginning of the year it was at levels around 0.2 - 0.3%. It is highly likely that LIBOR will continue to be higher than Fed Funds as it makes sense

Mortgages Rates

The average interest rate on a 30-year fixed mortgage is 6.7%, up from 3.3% at the start of the year. The average rate for a 15-year loan is 6% as of the time of writing

Corporate Bonds

To draw the yield curve we will use Back of America as a benchmark as it is supposed to be somewhat of a representative of an "A-" issuer in the corporate world

BAC Yield Curve

BAC Yield Curve (Interactive Brokers)

The yields are in the range of 4.5% to 6% and this is the typical yield curve for a company with such a rating

Fixed-Rate Preferred Stocks

We have over 100 fixed-rate preferred stocks with investment grade credit ratings by S&P or Moody's. Some of them are qualified for lower tax rates some are not but in general, their yields are in the range of 5.7% - 6.5% depending on company specifics

Fixed-rate preferred stocks BBB- or higher

Fixed-rate preferred stocks BBB- or higher (Proprietary Software)

CEF's Preferred Stocks

From a credit perspective, these are the safest preferred stocks on the exchange and their yields are in the range of 5.38% to 6.5% depending on the issuer and some tax differences.

CEF Preferred Stocks A- or higher

CEF Preferred Stocks A- or higher (Proprietary Software)

Today's Idea

The stock that got our attention is Allstate Corp., 5.10% Fixed-To-Floating Rate Subordinated Debentures due 2053 (NYSE:ALL.PB). We believe that this is a fixed income investment that is both suitable from a credit risk perspective and from an interest rate risk perspective. It carries a BBB rating by S&P and at the start of 2023 will be floating which is supposed to fight interest rate risk

Description of ALL-B

ALL-B is a fixed-to-floating Rate Subordinated Debenture issued by Allstate Corporation (NYSE:ALL). This exchange-traded debt security pays a fixed dividend of $1.28 per year until it becomes floating-rate security on 1/15/2023, and matures on 1/15/2053. After the call date, ALL-B will either be redeemed at par or pay 3.165% above the 3-month LIBOR. As of the moment of writing this article, the stock trades at around $24.48.This security is rated BBB by S&P and Baa1 by Moody's.

Possible Scenarios

The first possible scenario for ALL-B is to be redeemed. We think the redemption probability is quite high, considering the LIBOR rate. Let's see the numbers in the graphic below.

ALL-B Basic Info

ALL-B Basic Info (Proprietary Software)

ALL-B at a price of $24.48 has a Yield to call 16.17%. This is an enormous yield even in the current environment so this is the best possible scenario for an investor in ALL-B

The second scenario for ALL-B after its call date is to not be redeemed. That means ALL-B will become floating and its coupon rate will be 3.165% + 3 the month LIBOR. The 3-month LIBOR at the moment is at 3.60%, and as FED continues to raise rates it is supposed to raise as well. We will take a 4.15 % rate for the 3-month LIBOR at the call date. So the basic expectation for ALL-B if not redeemed is to have a floating rate of around 7.3% (4.15% + 3.165%). As long as the purchase price of ALL-B is below par, a possible redemption will always be positive that boosts return so the lower one can get at the moment is the floating 7.3%. Now we need to compare this to the yield curve of ALL and to its preferred stocks.

At the time of writing the fixed-rate perpetual ALL preferred stocks trade at around 6% current yield which is way lower than the expected floating current yield of ALL-B:

ALL family

ALL family (Proprietary Software)

The Corporate bonds of ALL can be seen here:

ALL Corporate Bonds

ALL Corporate Bonds (Finra Website)

These bonds are 2 notches higher compared to ALL-B and it is up to the reader if the 2% yield spread is fair keeping in mind that ALL-B is a floating instrument with embedded protection from rising yields. To us, the comparison is very straight forward and we believe ALL-B is way superior to anything presented in the article.

What about the common stock

At the time of writing the article, the dividend yield of ALL is 2.75% and the forward P/E ratio of the company stands at around 11. The so-called earnings yield of the company may sound tasty to many investors but with the current market uncertainty the common stock lacks embedded interest rate risk protection of ALL-B and the bond is far superior from a credit perspective. We can use the price behavior of ALL as an early signal for worsening credit and at the time of writing the common is as solid as possible in such a market downturn:

ALL vs SPY 1 Year chart

ALL vs SPY 1 Year chart (Seeking Alpha)

Conclusion

The fixed income sell-off brings some opportunities in the floating-rate space. Based on the logic presented above we believe that ALL-B has the potential to weather the storm and produce abnormal returns somewhere between 7.3% and 16% annualized while acting as a protection against rising yields.

Trade With Beta

At Trade With Beta, we also pay close attention to closed-end funds and are always keeping an eye on them for directional and arbitrage opportunities created by market price deviations. As you can guess, timing is crucial in these kinds of trades; therefore, you are welcome to join us for early access and the discussions accompanying these kinds of trades.

This article was written by

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Income arbitrage ideas along with managed portfolios and pair trades

Day trader whose strategy is based on arbitrages in preferred stocks and closed-end funds. I have been trading the markets since I started my education in Finance. My professional trading career started right before the big financial crisis of 2008-2009 and I clearly understand what are the risks the average investor faces. Being a very competitive trader I have always worked hard on improving my research and knowledge. All my bets are heavily leveraged(up to 25 times) so there is very little room for mistakes. Through the years my approach has been constantly changing. I started as a pure day trader. Later I added pair trades. At the moment most of my profits come from leveraging my fixed income picks. I find myself somewhere in between a trader and an investor. I am always invested in the markets but constantly replace my normally valued constituents with undervalued ones. This approach is similar to rebalancing your portfolio and I just do this any time there is some better value in the markets. I separate my trading results from my trading/investment results. I target 40% ROE on my investment account and since inception in 2015, I am very close to this target.


My main activity is running a group of traders. Currently, I have around 40 traders on my team. We share our research and make sure not to miss anything. If there is something going on in the markets it is impossible not to participate somehow. Some of my traders are involved in writing the articles in SA. As such Ilia Iliev is writing all fixed-income IPO articles. This is part of their development as successful traders.


My thoughts about the market in general:

*If it is on the exchange it is overvalued and our job is to find the least overvalued.

*Never trust gurus - they are clueless.

*Work hard - this is the only way to convince yourself you deserve success.

*If you take the risk it is you who has to do the research.

*High yield is always too expensive.


We are running a service here on SA. It is a great community with very knowledgable people inside. Even though we are not in the spotlight as often as we would like to our articles' results are among the strongest on SA. You can always contact me to share some of our articles and best picks so far.

Disclosure: I/we have a beneficial long position in the shares of ALL-B either through stock ownership, options, or other derivatives. 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.

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