Favorite weekly review: Choosing between SOFR/Libor and Treasury floats


Darren415

This article was first published to Systematic Income subscribers and free trials on November 7.

Welcome to another installment of our favorite weekly market review, where we discuss preferred stock 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 November.

Be sure to check out our other weekly updates covering the Business Development Company (“BDC”) markets as well as the Closed Ended Fund (“CEF”) markets for insights across the space. revenues.

Market Action

Preferences fell again this week, with November shaping up to be the fourth consecutive month of declines so far. Rising Treasury yields and falling equities were the main headwinds.

Systematic income

Systematic income

Retail preferred stock yields continue to rise and are at a 5-year high outside of a few days during the COVID crash. In our view, the sector remains an attractive place for new allocations.

Systematic income

Systematic income

Market themes

Over the past year, we have seen a significant increase in preferred floating rate issues linked to longer-term rates. Historically, retail preferred shares, i.e. preferred shares traded on an exchange, were either fixed rate or linked to the 3 month Libor after the initial 5 year fixed rate period.

The ongoing transition away from Libor has caused issuers to choose whether to stick with a short-term floating rate like SOFR or adopt a longer-term rate like the 5-year Treasury yield (that’s i.e. the 5-year CMT) as an anchor for the floating rate after the initial fixed rate period.

Recent issues have focused primarily on 5-year CMT, with SOFR being less common. This makes sense since most institutional preferred shares are also tied to 5-year rates, although most are also tied to 5-year interest rate swap rates in addition to the 5-year CMT rate. It may come as a surprise, but par interest swap rates are a more common benchmark of “interest rates” in the institutional space than Treasury rates.

That said, legacy 3M Libor preferences still dominate the industry. In our database that feeds our Investor Preferreds Tool on the service, we have 134 variable rate preferences linked to short-term rates such as SOFR and 3-month Libor and we have 26 linked to higher rates. long term such as 5-year Treasury yields, i.e. 5 years. CMT. So how should investors think about allocating to one or the other?

The following factors are important to consider in our opinion. First, there is the simple matter of diversification. It is very likely that most investors will be allocated primarily to Libor-linked stocks, so some allocation to CMT-linked stocks provides another source of portfolio diversification.

Second, it is important to consider the shape of the yield curve. Today, the yield curve is quite flat, which is quite unusual, as the following chart shows. The historical average spread between 5-year Treasury bills and 3-month Treasury bills is just over 1%.

Systematic income

Systematic income

This means that recent 5-year CMT issues have been made at very favorable rates compared to historical levels. In other words, if the yield curve returns to its historic level, the 5-year CMT indexed shares will gain an additional 1% compared to the Libor/SOFR indexed shares. Therefore, the current flat yield curve provides an asymmetric risk profile that favors CMT-linked stocks.

Finally, another reason to take a closer look at CMT-linked stocks is that the Fed has much less control over the longer end of the yield curve. In other words, if the Fed decides to suppress short-term rates, its ability to suppress longer-term rates will be limited in the absence of new and unusual measures such as yield curve control.

The risk for CMT-linked stocks is that the Fed decides instead to keep the policy rate high during a prolonged recession. In this scenario, which is already partly reflected in the yield curve, short-term rates could continue to be well above longer-term rates, which will benefit Libor/SOFR-linked equities. In our opinion, it is possible, but it is unlikely to be sustainable. In other words, there is unlikely to be a multi-year recession with the Fed keeping the policy rate high throughout.

The 5Y CMT-related favorites that are worth checking out are:

  • American Equity Invest Life Holding Co. 6.625% Series B (AEL.PB)
  • AGNC Investment Corp. Dep Shares Ser G Reset Rate Preferred (AGNCL)
  • Rhythm Capital Corp. Cumulative Preferred Series D Adjusted Rate (RITM.PD)
  • SiriusPoint Ltd Series B 8% Resettable Fixed Rate (SPNT.PB)

The main details of these stocks are presented below. The stripped yield is what those stocks are earning today and the reset yield is what those stocks are expected to earn when they move to floating rate.

Systematic Preferred Income Tool

Systematic Preferred Income Tool

This is how the returns on these stocks are expected to move over time.

Systematic Preferred Income Tool

Systematic Preferred Income Tool

Market Commentary

BDC Saratoga’s new 5-year bond (SAJ) started trading at a yield of 8.2%, which looks quite attractive. The company’s debt asset coverage was 184% at the end of the quarter and it would have decreased slightly with this new issue. The company’s net asset value has increased over time, which is good to see as it shows that its underwriting is strong, which should protect the debt. The bonds are not rated by a major agency but would likely sit around a BB level conservatively. They are trading around 0.9% above a typical BB corporate bond yield.

In case you missed it, NLY.PF has been transformed to (NLY.PG) in all taxable income portfolios. G underperforms until April 2023, but then transitions to around 0.7% higher yield than F over the long term (i.e. LT Reset Yield). Both series are trading at the highest price differential, with F at a high premium to G as it recently floated and surged to higher yield. However, once G floats, F will have a significantly lower yield.

Systematic Preferred Income Tool

Systematic Preferred Income Tool

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