This article was first released to Systematic Income subscribers and free trials on July 30.
Welcome to another installment of our Preferreds Market Weekly Review, where we discuss preferreds and baby bond market activity from both 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 some historical context as well as relevant themes that look to be driving markets or that investors ought to be mindful of. This update covers the period through the last week of July.
Be sure to check out our other weekly updates covering the BDC as well as the CEF markets for perspectives across the broader income space.
Preferreds enjoyed a torrid July, nearly offsetting the sharp drop over June. The rally in stocks, fall in Treasury yields and a tightening in credit spreads all contributed to a sharp rally.
Preferreds yields have moved lower as prices have rallied. Overall, they remain relatively attractive historically.
One of the most interesting aspects of preferreds sector performance so far this year has been the performance differential between Fix/Float and Fixed-rate preferreds.
Fix/Float preferreds have outperformed so far this year on the back of sharply higher short-term rates. The idea is that eventually higher short-term rates will allow Fix/Float preferreds to raise their coupon levels. For most Fix/Float preferreds the floating-rate coupon will be significantly above its current Fixed-rate based on Libor expectations. Because Fixed-rate preferreds don’t benefit from the rise in short-term rates they have not fared as well. Another way to think about this is that Fix/Float preferreds have a lower duration profile and, hence, were less vulnerable to rise in interest rates this year.
The chart below shows that Bank Fix/Float preferreds have outperformed their Fixed-rate counterparts.
However, it is always important for investors to avoid extrapolating current market trends forever. Over the last few weeks, the consensus has developed that the economy will enter recession which will cool off aggregate demand as well as inflation and allow the Fed to start reversing its prior hikes.
If this is correct, this can put Fix/Float preferreds in a tricky position as the tailwind of this year’s rise in short-term rates could easily turn to a headwind. As the recession has become increasingly priced in expectations of short-term rates and Treasury yields have moved significantly lower – 10Y yields have fallen to 2.68% from 3.5% in mid-June. This has allowed Fixed-rate preferreds to outperform in this period as shown below.
Overall, we still view some Fix/Float preferreds, particularly those with large spreads over Libor as very attractive in this environment. However, investors shouldn’t lose sight of the possibility that Fixed-rate preferreds, particularly those of higher-quality, can outperform in a “normal” recessionary scenario where interest rates fall across the curve.
AGNC and NLY book values fell 13% while DX fell 8%. Weakness in agency MBS relative to Treasuries continued to keep book values under pressure. There seems to be a lot of commentary out there that mortgage REITs are underperforming because of either rising rates or housing weakness but that’s not correct.
The primary driver of agency-focused mREIT book values is the MBS basis, i.e., the relative value between agency MBS and Treasury yields. Agencies have underperformed relative to Treasuries on the back of higher interest rate volatility, Fed’s planned balance sheet roll-off of agency MBS and simple mean-reversion from their previously very expensive valuations i.e. very tight MBS basis. A chart showing this relationship for DX is shown below with the rising MBS basis trendline highlighted alongside the falling trend in book value.
The relationship is not perfect because it focuses on the 30Y basis (not fully representative of the typical mREIT portfolio) and it also ignores other assets which can be more volatile, particularly in 2020. For example, DX book value rose in Q2-2020 despite a rising MBS basis because of the idiosyncratic behavior of agency CMBS IOs which tightened sharply as the delayed recovery in less liquid mortgage assets gathered pace.
The pace of book value drops should subside and possibly reverse going forward as agency MBS valuations are already pretty cheap and net mREIT interest margins are higher.
We currently like NLY preferreds over their AGNC counterparts even though both suites trade at roughly similar yields. NLY equity / pref coverage is higher at 7.2x vs 5.2x and its leverage is lower. It looks like the company has been more aggressively issuing common stock to support equity even as book value has been falling which has kept equity / preferred coverage from falling more sharply.