Investment Implications Of An Expensive Preferreds Sector

Preferred stocks are popular investment options with income investors due to their junior position in the capital structure and hence relatively high yield as well as their favorable tax treatment. The preferreds sector, as many other fixed-income sectors, has gone through a roller-coaster ride since the beginning of the year. The sector traded at a fairly expensive valuation at the start of the year, then sold off sharply and over the last six months has slowly approached its start-of-year valuation levels. In this article, we take a look at the state of this sector and the investment implications of recent trends.

Our main takeaway is that the sector’s increasingly expensive valuations has a number of knock-on impacts on investor portfolios. First, low overall yields mean fund fees create a larger relative drag on income. Secondly, an increasing number of stocks are trading at negative yield-to-call, which, with increasing call activity, points to greater returns from active management. And thirdly, low overall yields suggest a more defensive stance in the sector as the opportunity cost of doing so is relatively low. We discuss a number of sector securities that hit some of these points. However, as there is no single “best” option in the sector given the wide variety of investor utility functions, individual investors ultimately have to choose which security features they care most about.

We highlight a number of securities in the article, a number of which we hold across our Income Portfolios.

  • Global X US Preferred ETF (NYSEARCA:PFFD)
  • First Trust Preferred Securities and Income ETF (NYSEARCA:FPE)
  • Nuveen Preferred & Income Term Fund (NYSE:JPI)
  • Principal Spectrum Preferred Securities Active ETF (NYSEARCA:PREF)
  • Wells Fargo 7.5% Series L (NYSE:WFC.PL)
  • Annaly 7.5% Series D (NYSE:NLY.PD)

The State Of The Preferreds Market

The current state of the preferreds market can be characterized by the following four trends.

First, the sector has largely completed a nearly year-long roundtrip, with the last six months seeing sharp spread and yield compression.

Source: Systematic Income

Secondly, a growing number of stocks are trading at a negative yield-to-call.

Source: Systematic Income

Thirdly, call activity has been increasing back up to a more normal level after a period of inactivity due to slumping prices which created an unfavorable environment for refinancing activity.

Source: Systematic Income

Fourthly, yields have started to diverge within sectors as the market has begun to take a more differentiated approach to securities.

Source: Systematic Income

What impacts do these trends have on how investors should approach the sector? In our view, the key consequences of these trends are the following.

First, yield compression means that fund fees are a growing and sizable portion of the underlying portfolio yield. For example, the benchmark iShares Preferred and Income Securities ETF (NASDAQ:PFF) charges a 0.46% management fee. Relative to the yield-to-worst of the broader preferreds market of 2.86% as of 9 October, according to Nuveen, that fee eats up around 15% of the underlying income. This suggests investors should consider ways to maximize the underlying yields of the asset class by going with lower-fee passive options, tactically rotating into CEFs that are trading at attractive discounts (which, effectively, act as fee subsidies) and holding individual preferreds over funds, thus forgoing fees entirely.

Secondly, lower overall yields suggest that investors should think more carefully about the risk/reward on offer. A drop in asset yields means two things. First, the sharp run-up in prices over the last few months points to a broader market that is priced for perfection and suggests that the asset class has further to fall if we do have a drawdown. And secondly, low overall yields mean that the opportunity cost of moving up in quality is significantly lower than it was at any point since April. As we have discussed in other articles, moving along the risk spectrum of a given sector in an anti-cyclical way (turning more defensive as valuations become expensive, and vice versa) actually helps to generate higher longer-term income and total return.

The third consequence of these trends, particularly the increase in negative yield-to-call securities as well as yield divergence, suggests that investors should consider an active management approach to the sector. This means either individual security selection or using active management investment options such as active ETFs, mutual funds and CEFs.

In the sections below we discuss these consequences in some more detail as well as suggest individual securities that look attractive in the current environment.

A Quick Yield Recap

Before looking at how different investment options stack up against these sector trends, it’s important to take a quick detour and discuss what we mean when we talk about yield. Investors who have been tracking preferreds sector benchmark ETFs like PFF will have, no doubt, noticed that the fund’s yield has range-traded around 5-6% over the last few years. So, why are we talking about a 3% yield when this is so obviously below the yields of sector benchmarks?

Source: Nuveen

The key difference here has to do with something investors in individual preferreds are well aware of which is the yield-to-call versus stripped yield. To illustrate the dynamics of these two yields we construct a preferred stock with properties reflecting the broader market. The table below shows a stock with a fixed-coupon of 5.5%, trading at $27.50 with a call date in 2025. The stripped yield of the stock is around 5% while the yield-to-call is around 3%.

Source: Systematic Income

The stripped yield is simply what the stock is paying versus its clean price (5.5% x $25 / $27.42) while the yield-to-call also takes into account the capital loss of the stock’s clean price moving from $27.42 to $25 on the first call date of 1/1/2025. It is this capital loss which makes the yield-to-call lower than the stripped yield.

So, if we look strictly at distributable cash flow then the preferreds ETFs do indeed “earn” their 5% or so. However, any pull-to-par capital losses due to call activity comes out of the principal rather than distributions and so it can be easy to miss. The preferreds sector is far from the only sector with this dynamic – we covered some of this ground in an earlier article.

For example, high-yield corporate and municipal bonds are typically callable as well. The difference between high-yield corporate and municipal bonds is that their yield-to-call metrics are much easier to track publicly – various sources like FRED and S&P publish option-adjusted yields for these sectors. In fact, when investors talk about “yields” in the context of these two sectors they are usually talking about option-adjusted yields. The same metric, however, is not easily available for preferreds which makes the sector a bit less transparent for income investors. This often makes it appear more attractive relative to other sectors; however, this is just optics – comparing preferreds stripped yield to option-adjusted yields of other sectors is far from a fair comparison.

It has to be said that the yield-to-call, just as other yield calculations, is not perfect. The actual calculation, is, by convention, the yield-to-first-call. In this sense, it understates the value of the call option held by the issuer (i.e. overstates the yield-to-call) – since the issuer has multiple call options rather than just the first call. Secondly, we can argue that the yield-to-call also overstates the value of the option because, in practice, there are frictions to exercising the call, such as requiring the issuer to replace the funding, which is not cost-free. This means that many preferreds end up trading at a negative yield-to-call for years which makes the actual yield, as experienced by the investor, somewhere in between the stripped yield and the yield-to-call.

Of course, yield or income is not all there is to investing. It makes a lot of sense for investors who are bullish a given asset class to say long that asset class despite low yields. For instance, investors who are bearish on the US macro picture or those who want a portfolio hedge could very well stay long US Treasuries in the expectation of even lower yields despite the fact that US Treasury yields are not very inspiring.

However, those investors who think of themselves as income investors should keep this distinction in mind. Some income investors may say, well, I don’t really care about the fact that the yield-to-call in the sector is much lower – I just care about the actual cold hard cash that hits my brokerage account; whatever happens to capital/total return is out of my control. Our point here is that while you may not care about total return, total return cares about you. In other words, ultimately, the ability of your brokerage account to produce income is fundamentally tied to the account’s total capital. And ignoring total return is, by extension, ignoring the longer-term ability of the account to generate income.

Investment Options In The Sector

With that tangent out of the way, let’s take a look at what these sector trends mean with respect to the actual investment options at investor disposal.

Given the sharp yield compression in the sector, what can investors do to mitigate the growing impact of the fund fee? One obvious answer is to target lower-fee investment options. The average ETF fee of the preferreds sector is around 0.65%, the average mutual fund fee is around 1.4% and the average CEF fee is around 1.2%. One option investors have at their disposal is simply to go for the lowest fee option. In the case of the preferreds sector, this appears to be the Global X US Preferred ETF at just 0.23% or half the fee of the sector benchmark PFF.

The fund has not traded for very long, but in its relatively short trading history, it actually managed to outperform the large major ETFs in the sector. No doubt, the fund’s lower fee had a lot to do with it.

Source: Systematic Income

Apart from addressing the issue of the fee, PFFD, by virtue of being an open-end fund is also a relatively defensive option in the sector. The chart below shows historic drawdowns of different fund types in the preferreds sector. While a 30% price drawdown seems very large, it is quite a bit smaller than the average CEF price drawdown of 52%.

Some investors adamantly don’t care about CEF drawdowns. In our view, they should since these drawdowns caused about half of the funds in the sector to deleverage, hurting their earnings capacity and total returns. Large drawdowns also make it difficult for investors to lock in higher longer-term yields by rebalancing from securities with lower drawdowns.

Source: Systematic Income

The downside of passive ETFs is that they cannot respond to the overall drop in yields or a dispersion in yields in an intelligent way – they must simply buy the index. This requires them to hold many negative yield-to-call securities as well as securities that no longer offer attractive risk-reward. The obvious response to this is to go for an active ETF.

There are a number of active ETFs in the sector – three, by our count. However, they have two downsides. First, their fees run quite a bit higher than that of passive ETFs on average. And secondly, most do not have a sufficiently long-enough track record to gauge whether their additional alpha makes up for their higher fees. The only active ETF in the sector with a long-enough track record is the First Trust Preferred Securities and Income ETF which has traded since 2013. The fund’s return is marginally higher than that of the larger passive ETFs over the last five years.

Another way to approach the issue of decreasing yields and the growing fee “tax” is to allocate to CEFs that are trading at attractive discounts. While there are different ways to think about discounts, in the context of fees, they can be viewed as effective fee subsidies.

While this makes sense in theory, the trouble is that the preferreds CEF sector is currently fairly expensive with nearly half the sector CEFs trading at premiums. The sector is currently trading at a small premium, in aggregate, having come off a very expensive level more recently.

Source: Systematic Income

To illustrate how a premium acts as an additional fee on the fund consider the following income disaggregation chart of the popular Flaherty & Crumrine Preferred & Income Securities Fund (FFC). The fund is trading at a 7.1% premium. Given the fund’s underlying income level, the impact of the premium comes out to an additional 0.51% “expense” that investors are in effect not receiving. Of course, we can argue that the fund already has a relatively low fee and it can make up for its elevated premium with additional alpha. While those arguments are reasonable, it still means the fund has to do additional work in order to mitigate this extra “expense”.

Source: Systematic Income

In the fund space, we continue to like the Nuveen Preferred & Income Term Fund, trading at a 6.91% current yield and 2.3% discount. Unlike perpetual CEFs, term CEFs have two advantages. First, is their discount control – if/when they terminate the discount will move to zero. This makes them somewhat more defensive within the sector.

Source: Systematic Income

And secondly, this discount accretion to zero provides an additional tailwind we call the pull-to-NAV yield which is still trading at an attractive level for the fund.

Source: Systematic Income

Overall, the preferreds sector funds address some of the current challenges of the sector. There are funds that provide a way to mitigate fee drag, others position relatively defensively in the sector and yet more offer active management options to mitigate the impact of negative yield-to-call stocks. However, most of the funds in the sector tend to skew in the higher-quality direction. We can tell this from the mandates of several passive funds to overweight rated stocks as well as by the rating profiles of the CEFs which are significantly above the average rating profile of the sector. This means that the underlying yield-to-call profile of the fund sector will tend to be on the low side.

One way in which the preferreds sector is different from other income sectors is that it offers an easy way to directly acquire individual preferred securities. The advantage of going for individual preferreds securities is two-fold. First, it allows investors to construct the exact portfolio, yield and exposure profile they actually want. And secondly, it allows them to forego management fees. The downside, of course, is that it requires investors to do their homework in order to select the securities they want.

In the current environment of low preferred yields, the ability to select individual preferreds is especially valuable. As mentioned above, this is, in part, because, the majority of sector funds tend to skew towards higher quality-allocations, focusing on rated securities whereas about half of the retail preferred market is unrated by any major rating agency. By buying individual preferreds, investors can also tailor the coupon profile of the individual securities. Most funds hold a sizable portion of their portfolio in fixed-to-float securities which means that the portfolio stripped yields will reset lower with time unless short-term rates rise, which seems unlikely over the next few years.

The main downside of selecting individual preferreds is that investors are limited to the retail preferreds market. Retail preferreds tend to be more volatile than institutional preferreds, suffering greater drawdowns. They also tend to trade at tighter credit spreads, in large part, because the retail market is less efficient in gauging option-adjusted valuations.

Source: Spectrum

A way to mitigate this is to allocate part of the portfolio to an institutional sub-sector. Among the two ETFs allocating to the space we like the Principal Spectrum Preferred Securities Active ETF which has the lower fee of the two at 0.55% and the stronger return. There is also the added advantage of active management for a higher fee of around 0.10% versus the larger passive ETFs. A final advantage of institutional preferred ETFs is their lower drawdowns of around 25% versus about 32% for the retail-focused passive ETFs.

Source: Systematic Income

Within the individual preferreds space we continue to like the Wells Fargo 7.5% Series L – a non-callable busted convertible. This series tends to be panned by retail investors due to its unusual price of around $1360 which has to do with its non-callable, fixed-coupon structure as well as $1,000 “par” amount. However, the series trades at a 5.55% yield compared to the other WFC series most of which are trading at negative yield-to-call. The second-highest YTW among the WFC series is more than 1% below WFC.PL. The actual valuation divergence is greater than this since a callable security should trade at a higher yield than a non-callable security, all else equal, in order to compensate the holder for the short option. The yield differential between WFC.PL and its sector is at the highest point in the last five years.

Source: Systematic Income

We also like the Annaly 7.5% Series D which is trading just above “par” in clean price terms. The stock is the only fixed-rate preferred issued by Annaly (NYSE:NLY) and it compares favorably to the other series with one downside being that it is currently callable. Buying the stock at a clean price below “par” will ensure that no loss is taken in case of a call.

NLY.PD is trading at only a slightly lower stripped yield versus the other series. However, the other series will have a sizable step down in yield once they float which will very quickly erode their stripped yield advantage at the moment.

Source: Systematic Income

Takeaways

The current preferreds market features low yields, increased call activity, a growing number of stocks trading at negative yield-to-call and intra-sector yield dispersion. These trends suggest that investors should consider ways to position in a way that takes this into account. Low-fee passive ETFs are relatively defensive, have a lower expense drag on yields, but tend to tilt towards higher-quality and hence lower-yielding securities. CEFs offer active management, but are currently trading at premiums or overly tight discounts. Individuals securities allow investors to avoid fees but also require additional legwork. Ultimately, investors have to judge for themselves among the different investment options available as there is no single “best” way to address all of these trends.

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Disclosure: I am/we are long WFC.PL, FPE, JPI. 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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