This article was first published to Systematic Income Subscribers and Free Trials on March 27
Welcome to another installment of our weekly preference market review where we discuss market activity in the preferred and baby bonds of both the bottom-up, highlighting individual news and events, and the top-down, providing a broader market overview. We also try to add historical context as well as relevant themes that seem to be driving the markets or that investors should be aware of. This update covers the period up to the fourth week of March.
Be sure to check out our other weekly updates covering BDC as well as CEF markets for insights across the entire revenue space.
After a strong rally the previous week, preferred stocks were mostly down this week as rising Treasury yields kept pressure on the market. A partial rebound in equities as well as strength in commodity prices supported highly convertible sectors such as technology as well as the energy sector. Since the beginning of the year, only the energy sector has posted a small positive return.
On a monthly basis, preferred stocks are down for the third month in a row, although March’s performance is not as bad as the previous two months.
Preferred higher quality sectors such as banking and insurance have underperformed this year and are trading at historically high levels of yield, having underperformed longer dated Treasuries. For example, while 30-year Treasury yields have risen only 0.75% over the past six months, bank prime yields have risen 1.4%.
A fairly tough preferred stock market finally brought some good news for investors. The $1.5 trillion omnibus government spending packages recently passed last week included federal legislation that supersedes current Libor documentation in preference documentation.
For investors looking for a refresher on why this is necessary, check out our previous week on this topic. In short, the potential, if arguably very small, risk faced by investors holding Libor Fix/Float securities was that the Libor would be pegged to its previous value when it eventually dies out, as generally the preferred contractual language did not anticipate the scenario of the disappearance of the Libor.
The new law states that the 3-month Libor-linked preferred coupons (we have no other Libor terms in our database of 660 exchange-traded preferred shares) will be replaced by SOFR +0.262% on June 30, 2023 Specifically, the law authorizes the Federal Reserve Board of Governors to select a Libor substitute based on SOFR. It is important to note that the law provides a safe harbor provision to protect issuers from any litigation related to the change.
The reason Libor is being replaced by SOFR is for the simple reason that Libor levels are set by banks. We’re not saying this to throw mud at Banks – there’s nothing else they can do. Essentially, no short-term interbank lending takes place in an unsecured format (which is what Libor represents) and so banks are forced, as best they can, to estimate a rate at which they think they can lend or borrow in an unsecured short-term format. Of course, since there are no hard numbers, they can hang their hats on many bank traders who have looked into their market positions and written fun posts to read to each other in the forums of discussion. Unlike Libor, SOFR is based on actual transactions which makes it a true financial index. The only surprise here is not that Libor is being replaced, but why it took so long for Libor to disappear.
The reason for the extra 0.262% spread that investors will gain is mainly because SOFR has tended to trade below Libor. Indeed, SOFR is 1) a guaranteed rate (by Treasury bills) whereas Libor is unsecured, i.e. the less “risky” SOFR and 2) is a spot rate whereas the 3 month Libor is a 3 month rate – a “shorter” rate on a normal upward curve would be lower.
At this time, we do not know if the Fed will choose a SOFR term, i.e. 3-month SOFR to match the 3-month Libor term of the preferred stocks or if it will stick to SOFR in cash. It is important to note that the average 90-day SOFR rate available on FRED is not the same as the 3-month SOFR rate since the former is a historical average while the latter, like Libor, is a forward-looking rate.
In our view, there are two main mechanisms of impact on investors. First of all, SOFR has tended to be “trickier” than Libor because it is based on real transactions and is more susceptible to friction in the repo market. The chart below shows that SOFR has tended to be more volatile than Libor. This was also the case during the COVID market shock, although it is harder to distinguish it in the chart. This spike is arguably good for Preferred shareholders, especially if the spike occurs when the rate for the period is fixed (we assume that Preferred will not switch to daily SOFR fixings, otherwise it will have an impact but only very marginally) .
Second, the SOFR rate will be much less influenced by counterparty creditworthiness concerns. Libor tends to be very sensitive to bank credit issues, which makes sense as it represents an unsecured loan to a bank. The best way to visualize this is via the Libor/OIS spread which is the difference between the Libor and the equivalent forward rate for Fed Funds (OIS stands for Overnight Index Swap and is a way of transforming the daily rate “floating” Fed Funds into a fixed forward rate). This spread widened during times of stress and, in particular, during the GFC when bank credit risk was questionable. The fact that this dynamic does not feed into the prime coupons is bad for the preference holders since the current banking risk is perceived as very low and the spread differential of 0.262% between SOFR and Libor may not reflect the stress future banking from which preferred shareholders will not benefit. in the coupons they receive. Indeed, the preferred shareholders saw themselves withdrawing a small bet on the banking risk.
Overall, this (mostly) clear path is good for the preferred share market as it removes a clear question mark over the future behavior of Libor Fix/Float securities which make up 19% of the exchange traded market.
Position and takeaways
Although preferred stocks are expected to end the third consecutive month down, March is actually a good result for the market. Indeed, March was responsible for more than two-thirds of the rise in 10-year Treasury yields and yet it is posting by far the best monthly return so far this year. This suggests that most of the sell-off in January and February was driven more by a rise in prime credit spreads rather than Treasury yields, as the chart below also suggests.
This suggests that if credit spreads remain relatively stable from here, the weakness in preferences over treasury yields (i.e. sector beta over treasuries) should remain. lower than at the start of the year. The main risk remains that the Fed’s recognition of the need for excessive tightening to control inflation could lead to a recession. However, in this case, we would not expect Treasury yields to rise at the pace seen so far due to slowing demand and a likely inverted yield curve.
Overall, rising Treasury yields remain a major hurdle for the market. Powell has staked 50 basis point hikes in future rate decisions, helping propel 10-year Treasury yields up 0.76% since March 1. If the Fed tightens too much, as the new dot plot suggests, and the economy falls into recession, the Treasury yield curve is likely to flatten (i.e. when long yields term fall faster than short-term yields) in which case the 10-year Treasury yield is likely to drop below its current level, supporting higher-quality preferred stocks.
For this reason, in addition to the fact that credit spreads are still expensive, we continue to like higher quality stocks as well as those with a consumer element like mortgage REITs, as consumer health is quite strong and the sector provides diversification to income portfolios that are traditionally overweight corporate credit risk and equity risk.
We covered our hybrid mortgage REIT picks in a recent article on the consumer sector. On the premium side, we like a few non-redeemable stocks – the Wells Fargo 7.5% Series L (WFC.PL), a split non-redeemable investment-grade stock trading at a yield of 5.86% or 3, 26% above long bonds (i.e. the 30-year Treasury) and Liberty Broadband Series A (LBRDP) – a quirky company whose holdings consist mainly of shares Charter Communications (CHTR) – a giant of telecommunications with a market capitalization of nearly $100 billion, trading at 6.42% yield.