Weekly Preference Review: ETF Rebalances Push Preferences
This article was first published to Systematic Income subscribers and free trials on October 9th.
Welcome to another installment of our weekly Preference Market Review, where we discuss preferred bond and baby bond market activity both from the bottom up, highlighting individuals news and events, as well as top-down, providing an overview of the wider 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 week of October.
Be sure to check out our other weekly updates covering BDC as well as CEF markets for insights across the entire revenue space.
The preferred shares sector fell slightly in the first week of October as yields on long-term Treasury bills rose somewhat. September was the worst month for space since March 2020 and October has yet to bring much relief.
All privileged sectors are now in the red since the beginning of the year, even the energy sector.
Preferred share yields have reached new highs, as shown in the following chart.
However, credit spreads have not reached new highs and remain at average levels.
Although yields have risen significantly, the preferred stock sector is far from at a difficult level, suggesting that higher quality preferred stocks make more sense for new capital allocation.
The preferred share market is going through one of the most volatile times in recent history. However, even by this metric, month-end price action in September was unusual, with many favorite stocks trading in high single digits.
We specifically recorded big moves in NLY favorites. As is often the case, when we see month-end volatility, ETF rebalancing is likely the culprit. The following table shows the holdings of NLY preferred shares by the largest preferred fund iShares Preferred and Income Securities ETF (PFF).
The chart shows that the fund bought 150,000 NLY preferred shares on September 30, which equates to around 90% of each share’s daily volume. This all happened in the last half hour of trading, as seen in the following 30 minute volume bar chart.
This kind of volume at the end of the day on Friday will leave its mark. The following chart shows the average daily total return of the 3 NLY preferred stocks, which was unusual in the post-COVID era.
The obvious question is whether investors can take advantage of this kind of momentum. In theory the answer is clearly yes, but in practice this is unlikely for the vast majority of investors. To take advantage of this model, investors should know the performance of the underlying index as well as how the fund manages index sampling. The strong rally in all 3 stocks along with the lack of significant gains before the jump also suggests that the pattern is likely difficult to monetize. Investors can take advantage of this model, however, by providing liquidity to the funds, i.e. selling on big rises and buying cheap securities on big declines, in the hope that returns will eventually renormalize.
This week, we’ve added a number of titles to our toolset. Specifically, we’ve added the favourite, fractional premium Banks’ favorite Series H (KEY.PL), which trades at a discounted yield of 6.36%, as well as the lower-grade Merchants Bancorp Series D (MBINM), which is trading at a discounted yield of 7.96%. . Both actions are the best choices in their suites.
The BB+ rated surname Ford 6.5% 2062 bond (F.PD) has been added to the Baby Bond Tool. It looks more attractive than F.PC and is trading at a yield of 7.01%. It’s a good choice for investors looking to buy a decent quality bond with a longer duration.
Position and takeaways
This week, we moved from Repurchased Floating Rate Preferred Bank (PNC.PP) to another ZIONO Preferred Bank (from Zions Bank (ZION)) in our Defensive Income Portfolio. ZIONO will float in March 2023 unless redeemed. ZIONO’s reset yield is 8.9%, i.e. this is the yield it will have at the current price on the first call date (March 2023) of Libor futures current, which is pretty good. It could also be redeemed, but if that happens, YTC is decent at 6.3% for 5 months.
The Fed’s hawkish discussions are putting some pressure on the markets. Mary Daly (SF Fed chief) said she doesn’t expect any policy rate cut next year. Raphael Bostic (Head of the Atlanta Fed) said he wants to see the rate go up to 4-4.5% and stay there for a while. OPEC’s decision to cut production by 2 million barrels – the most ever (to keep Brent above $90 it seems) – should keep pressure on inflation and prevent the Fed to quickly reverse the increases. This should, in turn, continue to support preferences that will be reset over the next year like ZIONO, NLY.PG, and others that are all worth checking out.