Preferred Share Target Updates and Alternatives
We’re updating the targets for a handful of preferred shares.
The focus here is pretty simple.
A fixed-rate preferred share value should be a function of:
The coupon rate (doesn’t change) compared to other yields (do change).
The call risk (combination of call protection and call value).
The credit risk for that company.
Interest rates ripped higher.
That’s a bigger challenge for fixed-rate shares than floating-rate shares of fixed-to-floating shares.
Adjustments
To account for other yields going up, we’re requiring a higher yield on the fixed-rate shares.
Most of the fixed-to-floating shares will float pretty soon, so the impact would be minor (such as 0.5% or less).
I may do another round of adjustments later to get those tiny adjustments, but 0.5% is pretty small.
To account for the swing in rates, we’re dropping the fixed-rate preferred share targets by 3%. The adjustments are already live in the sheets.
Disclosure
At the time of publishing, I own DX-C, RITM-D, RCB, EFC-B, MFAN, CIM-D, PMT-C, RITM-B, RITM-C, GPMT-A, EFC-A.
I also own common shares of RC, RITM (very small) and GPMT (very small).
Favoring Fixed-to-Floating
Given the current momentum in rates (moving up quickly), I would be inclined to favor fixed-to-floating shares at similar discounts to target prices.
An early floating date can trigger coupon rates to increase significantly.
The higher coupon rate can improve price stability as more investors are drawn toward the high yield.
The fixed-rate shares we cover are:
EFC-D
ARR-C
RC-E
PMT-C
CHMI-A
FBRT-E
MFA-B
CIM-A
NYMTZ
MITT-A
MITT-B
Deals to Avoid
A few shares to avoid:
2 fixed-rate shares (EFC-D and CHMI-A)
1 floating-rate share (in the exclusive section)
We have alternatives for all of these shares in the exclusive section.
Walk Away From EFC-D
The first one is EFC-D (EFC.PR.D) (EFC.PD).
We gave the EFC preferred shares a risk rating of 2.5.
That’s a bit lower than average, but not much.
When we compare EFC-D to the other fixed-rate preferred shares:
EFC-D has the lowest stripped yield at 8.16%.
EFC-D has the second lowest discount to call value at $3.42.
A share with the lowest stripped yield and the second lowest discount (less upside if rates fall), should have the least credit risk.
Is that the case?
Comparing Other EFC Preferred Shares to Sector Peers
The rest of the EFC preferred shares don’t look like it.
EFC-E: Already floats. 5.664% spread. $25.15 with $.22 of accrual. Stripped price $24.93. Floating yield about 11.28%.
AGNCN: Already floats. 5.111% spread. $25.25 with $.14 of accrual. Stripped price $25.11. Floating yield 10.65%.
Either share could be called promptly. AGNCN offers investors a lower yield, but carries more call risk. Clearly, investors are treating EFC-E as riskier than AGNCN.
EFC-A: Floats 10/30/2024. 5.196% spread. $23.58 with $.09 of accrual. Stripped price $23.49. When floating yield on current price would be 11.48%.
AGNCO: Floats 10/15/2024. 4.993% spread.$24.22 with $.09 of accrual. Stripped price $24.13. When floating yield on current price would be 10.96%.
Once again, the market has judged the EFC preferred share as requiring a greater rate of return.
The market isn’t demanding a huge rate of return, but it isn’t the absolute lowest risk.
It would be better if we could use fixed-to-floating shares from the other REITs with similar risk ratings, but several of them don’t have fixed-to-floating shares.
ARR-C, RC-E, PMT-C, and FBRT-E don’t have good fixed-to-floating sister shares for comparison.
PMT-C has PMT-A and PMT-B, but the prices are still distorted by management’s claim that the shares won’t float based on the LIBOR Act. Management never elaborated on how the LIBOR Act would result in those rates being fixed. All of PMT’s peers determined that their fixed-to-floating shares (some with extremely similar language) were required to float under the LIBOR Act. Consequently, we can’t use PMT-A and PMT-B to judge the required floating yield.
EFC-D Vs. MFAN
Wild comparison.
EFC-D has an 8.16% stripped yield and no maturity. Shares can be called, but it is always the option of the REIT.
MFAN is a baby bond with a 9.58% yield to maturity. Shares can be called, but on 2/15/2029 (if no earlier call), the company must redeem them at face value (or face bankruptcy).
Interest payments must be made on time. The REIT could call the baby bond, but maturity is in the contract at 2/15/2029. Fixed maturity is nice.
MFAN has a BBB- credit rating from Egan-Jones (not one of the big 3, but still something).
The potential upside for EFC-D of returning to $25.00 if interest rates really plunge (without a recession) is around 16%.
Is that really enough upside to take EFC-D at 8.16% over MFAN at 9.58%?
I say no.
If rates do not decline materially, then MFAN easily wins by virtue of a higher yield.
Note: Part of MFAN’s yield comes from the stripped discount to face value. Shares are over $25 at $25.20, but there’s about $.68 of interest accrual so far.
For a baby bond, due to the maturity date, the yield can swing much faster from a smaller price movement. That encourages more price stability since bargain hunters will come in for a much smaller discount.
I can’t see any reasonable case for EFC-D to carry a materially lower yield than MFAN. Investors are really gambling on rates falling. However, they could’ve used one of the other fixed-rate shares to have far more upside in that scenario.
Stripped Yield and Upside Comparison
Stripped yields:
You should also see the potential upside to call value for a best case scenario:
We’re not anticipating that best case scenario, but it helps to know the potential gains.
CHMI-A
CHMI-A also has one of the lower stripped yields. If we exclude EFC-D, it would be pretty close to the lowest stripped yield (9.08% vs 8.72%).
CHMI-A is the preferred share with the smallest discount at $2.32. If we adjust for dividend accrual, it would be $2.43.
That gives it the least upside, so it isn’t a great pick for gambling on rates falling.
The market simply likes CHMI-B (fixed-to-floating) and CHMI-A far more than I do.
CHMI had total book value for common and preferred shareholders (combined) of $255.47 million at the end of Q4 2023.
Out of that $255.47 million, there was $119.54 million attributable to the call value on the preferred stock. That’s 46.8% of total “equity” being preferred equity.
That makes these preferred shares more dangerous.
Yet CHMI-A has:
The least upside.
Below-average stripped yield.
A lower stripped yield than the yield to maturity for MFAN.
More risk than several (not all) of the other securities mentioned here.
Two major topics left:
One floating-rate share to avoid.
Suggestions for replacing these shares.