Preferred Weekly Market Review: Assessing the risk/reward of debt versus debt. Favorites
This article was first published to Systematic Income subscribers and free trials on January 24.
Welcome to another installment of our weekly preference market review where we discuss activity in the preferred bond and baby bond market both from the bottom up, highlighting individual news and events, as well as top to bottom, providing insight into 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 third week of January.
Be sure to check out our other weekly updates covering BDC as well as CEF markets for insights across the entire revenue space.
The favorites did not come out unscathed, with all sectors finishing lower this week. That said, the movements in most sectors have not been extreme and, since the beginning of the month, three sectors are still in the green.
Unlike its CEF counterpart, the monthly situation in the preferred shares sector is rather benign. January’s total return is still higher than it was for November and October of last year. In contrast, the CEF market total return in January was the worst since March 2020.
Most of the weakness in the CEF market was due to widening discounts – the absence of discounts on preferred shares has allowed the sector to remain more resilient, as we highlighted in a previous article comparing the two types of assets.
Investors in senior securities (i.e. preferred stocks and secondary bonds) sometimes have the choice of investing in either a preferred stock or a bond of the same issuer. Historically, many investors would simply buy the best performing senior stock, whether it be bonds or preferred stocks, however, the experience of the COVID downturn and recent market volatility has raised many questions. on how to think about the risk/reward of going for a bond or a preferred.
To give an idea of how investors might think about risk/reward when allocating to bonds versus futures preferences, let’s look at the case of popular CLO Equity CEF Oxford Lane Capital Corp (OXLC). The fund has three term preferred shares and two bonds outstanding.
This is how the balance sheet piled up at the end of the year.
Many investors tend to consider that there isn’t a big difference between 200% (for preferred stock) and 300% (for debt) asset coverage in the capital structure, so might as well opt for for the higher yielding stock.
There are three problems with this approach. First, the 200% to 300% rule of thumb doesn’t really take into account the realities of individual issuers’ balance sheets. For example, in the case of OXLC, debt currently carries an asset coverage of 716%, while preferred stock has an asset coverage of 344%. And where preferred stocks will have 200% coverage, bonds will have 417% coverage, rather than 300%.
Second, as we discussed earlier, asset coverage is not a very useful metric for preferred stock because it ignores the relative amounts of debt and preferred stock in the capital structure, lumping them together.
And third, focusing on asset coverage doesn’t provide enough insight to weigh the risk and reward of debt and preferred stock, that is, unless you’re Rain Man.
A good way to get a feel for the risk/reward ratio between debt and preferred stocks is to consider how much each type will get under various upside scenarios on the underlying assets. The two lines below plot the relative gains for each. For example, if the underlying assets get back 10% (on the x-axis), the debt will be repaid at 72 cents on the dollar (orange line) while the preferred stocks will get nothing (grey line). On the other hand, if the assets get back 25%, the debt is fully paid off while the preferred stocks get 73 cents on the dollar.
In our view, this type of analysis is more useful than the traditional focus on asset coverage. Investors can use these gains when considering the yield differential offered between different types of securities.
As previously highlighted, CLO Equity fund Eagle Point Credit Co (ECC) is redeeming preferred stocks (ECCB) and bonds (ECCY) and (ECCX), the latter partially, on the back of its recent issuance of (ECCV). This should give the fund’s earnings a small boost as it buys back securities with coupons of 7.75% (ECCB), 6.75% (ECCY) and 6.6875% (ECCX) and replaces them with a other paying 5.375% (ECCV). For ECCY and ECCX bonds, this is a good example of why it may make sense to move towards lower/preferred coupon bonds among those that are currently callable. ECCX has a slightly lower coupon, so it is only partially redeemed while ECCY, which has a higher coupon, is fully redeemed.
The two bonds tended to trade at very similar yields, so investors didn’t give up any yield by going for the lower coupon. In addition to potentially improving their call protection due to issuers’ tendency to redeem their highest coupon securities first, it also often improves yield, as higher coupon securities often trade at lower-call yields (because many uninformed investors simply go by current yields rather than call yields).
This, of course, doesn’t always work as issuers sometimes fully redeem multiple bonds/preferred shares, like when TWO did this a while ago. However, in the case of ECC, this means that the remaining ECCX shares can squeeze a few more coupons at an attractive risk-reward ratio.
The favored sector for mREITs is one that remains quite compelling in this environment as it offers relatively higher yield with many stocks exhibiting yields beyond 7% and one that exhibits many different types of coupon profiles, which can be convenient for investors looking to diversify their interest. exposure rate.
For investors specifically concerned about the impact of rising rates on the typically very long duration preferred stock sector, some of the fixed/floating options that should hold up better at higher rates are New Residential Investment Corp. Series D (NRZ.PD) which resets at the coupon of the 5-year Treasury yield (i.e. 5-year CMT) +6.22% in 2026, currently trading at 6.97% YTC. The Granite Point Mortgage Trust Series A (GPMT.PA) resets at a coupon of SOFR +5.83% with a floor of 7% in 2026 and trades at a YTC of 6.91%. What is interesting with this latest coupon structure is that the coupon will not fall below the current fixed level of 7% but can also participate in higher short-term rates.
Position and takeaways
Our lower beta playbook performed well in this latest draw. Niche sectorshighlighted below, outperformed the broader income space.
Pinned titles at par mostly outperformed in their sectors last week. Overall, our watchlist pinned on the service generated a -0.2% return compared to a -1% return for the average sector.
Shorter Maturity Securities both preferred stocks and bonds also outperformed, delivering a stable performance for the week.
In terms of allocation, we recently rotated from the XFLT 2026 (XFLT.PA) series which fell below 3% YTC to the mREIT Arlington Asset Investment Corp 2025 (AIC) bond which is currently redeemable ( without call price risk). This improves the performance profile and reduces duration while maintaining a high quality profile. The traditional low-duration loans of many income portfolios are loans, however, these tend to be of relatively low quality, particularly those held by CEFs, with a sweet spot around the unique B zone (a level rating in front of CCC) which is not terribly well suited for a defensive position. This means that investors who wish to maintain a more defensive stance should consider higher quality securitized assets such as ABS and MBS as well as shorter-dated senior debt.
Overall, the recent dip hasn’t opened up a whole lot of new opportunities, as most favorite sectors are still up over the past month. However, this resilience of the sector has the advantage of offering a stable source of capital to reallocate to underperforming parts of broader income sectors such as CEFs. For example, the chart below shows the performance of different pockets of our high income portfolio with preferred bonds and baby bonds around zero and CEFs underperforming.
This reallocation between different types of investment vehicles can allow investors to take advantage of development opportunities across the income space by moving capital from more stable parts of the portfolio to those offering an improved value proposition. This is a strategy we have preemptively pursued over the past year in our portfolios by reallocating the CEF sleeve to preferred shares and BDCs and it is a strategy we will look to reverse if weakness of the CEF market continues.