This article was first published to Systematic Income subscribers and free trials on July 11.
Welcome to another installment of our weekly Preferences Market Review, where we discuss Preferences and Baby Bonds market activity from the bottom up, highlighting individual news. and events, as well as top-down, providing an overview of the broader market. 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 first full week of July.
Be sure to check out our other weekly updates covering BDC as well as CEF markets for insights across the entire revenue space.
Preferred shares had a strong start to the month as the broader credit rally was a tailwind. Even the pullback in Treasury yields this week was not enough to push the sector into negative territory. That said, June was clearly a very difficult month and it will take time for the sector to come out of it.
A sharp tightening of credit spreads led to a decline in the sector’s overall yield, but it still remains historically high and attractive in our view.
A good way for investors to retain a sense of direction and context is simply to understand how the current valuation of a given asset fits into its larger history. In short, knowing whether the asset looks historically expensive or cheap can allow investors to see how it matches the underlying fundamentals as well as the investor’s outlook for the medium-term macro picture. In this section, we briefly review the longer-term valuations of the preferred share sector from different angles.
Let’s first look at the returns of preferred stocks and treasury bills over the past decade, as shown in the chart below. What we see is that outside of the very brief COVID shock, preferred stock yields are currently very high. This is both a function of the simple fact that treasury yields are high and that credit spreads (i.e. the yield spread between preferred stocks and treasuries) have also increased. . It’s also important to note that the chart below is from May 27th and the preferred share sector has fallen around 5% since then, i.e. yields have risen another 0.3 % about.
Spectrum Asset Management offers a different kind of valuation perspective. They compare the current market to three previous credit cycle lows in preferred stocks (they don’t include the COVID period) in 2013 (the initial crisis), 2016 (the energy shock) and 2018 (the autopilot crisis) .
What we see is that at the end of May, the preferred stock market was trading at a credit spread of 3.1% versus an average of 4.25% over these three periods. . However, taking into account the weakness in June, this now brings us quite close to the average valuation of these periods.
Taken together, these two outlooks again show that the preferred stock market is trading at very attractive valuations. None of this suggests the sector is safe from more pain, but adding to current levels is not an obviously stupid thing to do in our view.
There was some unusual price action the week before that is worth highlighting. Two of NYMT’s three favorite stocks fell around 4% despite an overall flat market and no change in fundamentals.
The culprit, as the table below suggests, was probably the ex-div date. Normally, the stock’s total return would be zero on the ex-div date because the falling price offsets the falling dividend. However, we often see a drop in the price well above the size of the dividend. Often, this is likely due to investors gambling on capturing and selling dividends on the ex-div date. And, as the results show, it probably doesn’t work very well for some of those who do. In fact, we would take the other side of the game ex-div, buying on the big dips (in total return terms) on the ex-div date, because the dip then tends to reverse the following week, while as it was in this case.
We continue to love NYMT favorites. We are currently neutral between NYMTM and NYMTN, as we consider them fairly priced relative to each other. As the following chart shows, the NYMTN has a considerable return advantage over the NYMTM for a few years, which then turns into a lesser disadvantage over a longer period.
Position and takeaways
We have not changed our allocation position this week as the market has been unusually fairly stable since the second half of June. This is due to the normalization of the relationship between Treasury yields and credit spreads, as they have now started to move in opposite directions, softening the impact of each other – a big change from what we saw earlier in the year as the two moved together, generally higher. .
This type of “normal” market behavior is expected when the market is driven by growing fears of recession rather than fears of inflation. Inflation expectations over the next 5 years have fallen from 1% in Q2 to just 2.6% to the same level as about a year ago, long before the word ‘transitional’ was canceled by the Fed . And even though the Fed no longer uses the word, it seems the market has, in fact, resurrected it. The obvious risk remains that inflation turns out to be more persistent than the market imagines.
This is why we continue to favor an allocation to higher quality variable rate (or soon to be floating) preferred shares such as the PNC Financial Services Group 6.125% series P (PNC.PP) with a 3 month Libor + 4 coupon .0675%. , Valley National Bancorp 5.5% Series B (VLYPO) with 3 month Libor + coupon of 3.578% and Annaly Capital Management 6.95% Series F (NLY.PF) with 3 month Libor + coupon of 4.993 % when floating in September. With a 3-month Libor expected at the end of 2022 around 3.25% (it is currently around 2.35%), this would equate to a rise in stripped yields to 7.32%, 7.33% and 9.2% .