Preferred Share Thoughts
Preferred share markets clearly are not efficient. We’ve demonstrated that valuations can deviate dramatically between shares with:
The same credit risk and
comparable future cash flows.
I want to preview a few upcoming adjustments.
A Confession
This was supposed to “Brief Preferred Share Thoughts”.
A few thousand words later, that title is no longer accurate.
I apologize in advance for any errors that slip through. Given the length, there will probably be some.
Target Adjustments
These are presented on a general basis. I’ll be more precise when we’re making the adjustments.
Fixed-rate share targets: We could see targets going up if the trend lower in rates continues a bit longer. Even if the trend downwards slowed, rates moving further below the 100-day moving average would be a strong signal.
PMT-A and PMT-B: When I adjusted targets lower in the wake of management’s fixed-rate announcement (which I still contend is wrong), I didn’t expand the ranges. At the time, I didn’t have as much evidence that management was wrong. Now that CIM and TWO have made announcements confirming my interpretation, it seems appropriate to fix the “overpriced” targets. They should probably be set a little bit above “$25.00 plus dividend accrual”. In essence, I would try to permit a slightly negative “worst cash to call” before the overpriced label triggers.
Fixed-to-Floating shares: There are quite a few fixed-to-floating shares that will merit small increases in targets. Why? Because we’re a few months closer to the floating rate kicking in. On a simple cash flow basis, when we move past a (hypothetical) dividend of $.40 and closer to a dividend of $.60, that’s probably grounds for an extra $.20 in the targets. That’s how we would represent a steady rate of return to the share. However, there’s a strange conflict here.
The Fixed-to-Floating Conflict
One of the biggest challenges I’ve had with setting targets here is that I am forced to pick one of the following:
The targets that best reflect the long-term future cash flows to a buy-and-hold investor adjusted for the level of risk.
The most likely targets to result in short-term capital gains based on what the market is likely to do.
Some hybrid that mixes elements of both.
There will not be any consensus on which is best. After struggling with this question previously, I settled on:
In a more efficient market, options 1 and 2 would be in near-perfect unison. That just isn’t the case. I’m forced to contend with some frankly absurd markets. However, we have enough history to predict which shares are more likely to receive a strong bid from the market.
Conflict Examples
NLY-F and AGNCN were the original two shares to become overvalued relative to peers. The difference in cash flows reached levels that were utterly insane.
I was shocked to see the magnitude of the mispricing the market created. However, there was a strong argument for some buyers to simply follow the signal from the market.
The main lesson here was that the market undervalues fixed-to-floating shares before they float relative to the value it assigns after they float.
To give a demonstration, on November 3rd, 2022, I wrote:
Sell AGNCN at $23.89. Buy AGNCO at $19.68. Collect the difference of $4.21. Lose out on the difference in dividends over the next two years. That difference will most likely be around $1.60. Maybe as much as $2.00 if Jerome Powell goes nuts in his attack on the economy. If you miss out on $1.60 to $2.00 over two years but you saved $4.21, was that a good deal or a bad deal?
The following chart shows how prices had changed leading up to that day. I enhanced it with some arrows and text.
Now what do you think happened from there?
AGNCN and NLY-F had already outperformed to a hilarious degree. They still had a big yield, but they didn’t have the same potential for capital gains. Consequently, performance was much stronger for the other shares:
AGNCL is a bit of an outlier. It started with a high coupon rate, but it is a fixed-to-reset security. It will reset with the 5-year Treasury, but it doesn’t happen for quite a long time. It can deviate from the other shares quite a bit.
Which 2 shares had the biggest rally since November 3rd, 2022?
It was NLY-G and AGNCM.
Why do you think that was? Because those two had the earliest floating dates. NLY-G is already floating and AGNCM is the next one to float. Investors piling into those names pushed prices higher.
On a cash flow basis, those are not the most attractive shares. However, the early floating date drove them to stronger performance.
The errors in pricing today are not as massive as they were with AGNCN and NLY-F at that point. Though, to be clear, those specific errors have not finished playing out.
Those Errors Still Exist
Prices:
AGNCN is $25.44.
AGNCO is $23.44.
Exactly $2.00 difference.
AGNCO floats starting 10/15/2024. That’s 4 dividends from now.
Assuming short-term rates are roughly unchanged over that period:
AGNCN pays out $2.67 in dividends.
AGNCO pays out $1.63 in dividends.
The difference is $1.04.
The gap in share prices is $2.00, but the difference in future dividends is $1.04.
What’s better:
$1.04 in your pocket across the next year
$2.00 in your pocket today
Don’t tell the market. It refuses to believe. It still thinks the valuations are even, regardless of the difference in cash flows.
What if short-term rates are lower one year from now?
Well, then, you’ll probably wish you bought a fixed-rate share instead. We don’t focus our analysis on predicting large changes in interest rates. That market is too large. We want to operate in a little niche where inefficient prices pop up.
I’m open to hearing any reason that someone would pay materially more for AGNCN on 10/16/2024 than they would for AGNCO:
AGNCN has a spread of 5.111%.
AGNCO will have a spread of 4.993%.
The difference is inconsequential.
So why would anyone pay materially more for AGNCN on 10/16/2024 than they would pay for AGNCO?
Both shares will float. If short-term rates are lower on that day, that’s equally “bad” for both shares.
The Bigger Picture
I’m not just trying to highlight the pricing failure between AGNCN and AGNCO.
I also want to highlight the issue it represents for targets. If I try to just apply a steady rate of return to shares, then I would upgrade targets in accordance with the change in remaining cash flows. However, that’s a bit too simplistic. It shouldn’t be. Mathematically, it would be right. But the targets already include some adjustments to reflect that the market will overvalue certain shares relative to others. Thus far, I believe our adjustments to reflect expected pricing failures have resulted in more effective and actionable price targets.
Therefore, investors should expect several minor adjustments to targets.
When I revise the targets, I also publish an article for our paid members indicating what adjustments have been made. There are usually a few brief notes explaining the reasoning for the adjustments. However, it will probably include dramatically fewer words than this article.
To be fair, this article should probably contain dramatically fewer words.
Sometimes, things don’t go quite as planned. The end result isn’t quite what you were expecting when you started.
Other Thoughts
I have a few more preferred shares (and some baby bonds) I want to share some thoughts on.