New York City, April 18, 2023 ~ Preferred Stocks, commonly referred to as hybrid securities, are fixed income instruments that generally offer investors high levels of current income, as compared to other fixed income asset classes. However, we have found that not all preferred stocks are created equal (from contractual rights, call features, instruments types, to credit considerations), and thus active managers should consider how to best utilize preferred stocks under the current market environment. We discuss below floating and fixed-to-floating rate preferred stocks and consider the investing implications in 2023 and 2024.
Both floating and fixed-to-floating rate preferred stocks offer investors a benefit of correlated interest rate exposure. Managers can utilize these types of preferreds to hedge interest rate risk, or to simply capture total return or high current income opportunities.
Floating Preferreds:
These types of preferreds contain an adjustable rate coupon that normally resets periodically based on a methodology. For example, we are seeing 3-month LIBOR (or LIBOR-equivalent) plus 3% for some instruments.
Fixed-to-Floating Preferreds:
These types of preferreds IPO at a fixed rate coupon for a predetermined set of time (usually 5 to 10 years) and then subsequently convert to floating preferreds. We noticed that the floating date for many of these preferreds corresponds with the first optional call date by the issuer. Similar to floating preferreds, the preferred stock offering documents usually contain a predermined methodology that will be utilized by the issuer in the event the preferreds convert to floating (i.e., 3-month LIBOR plus 3%).
The recent banking crisis in 2023 has caused equities and fixed income securities to sell off as investors reduce margin or risk in their portfolio. On a daily basis, we create a basket from the investible universe of preferred securities based on a variety of factors, and have noticed dislocations across preferred instrument types and parity preferred issues of the same issuer. We believe active managers can seek total return and high current income by arbitraging gaps that emerge when: (1) floating preferreds trade in-line with their fixed rate preferred parity issues, (2) fixed-to-floating preferreds are converting in the near future at higher coupon rates, and (3) management is encouraged to call these floating preferreds at par value when interest rates are high.
Active Management Example:
As discussed above, many $25 preferred stocks convert to floating rate 5 years after the issue date. In today’s interest rate environment, with the yield curve inverted, this can provide a large immediate increase in income upon the conversion. After conversion, the increases/decreases will be more modest as the Fed adjusts the Fed Funds rate. As an example of the magnitude of the initial bump, SCE Preferred H converts from a fixed coupon of 5.75% to 3-month LIBOR + 2.99%. At 3-month LIBOR as of 4/10/2023, this equates to a current yield moving from 6.90% to 9.80%, or a more than a 40% increase to its dividend.
*Information and underlying data are sourced from Bloomberg as of 3/31/2023. Investment professional use only. The S&P U.S. Preferred Stock Index (SPPREF) is a benchmark representing the U.S. Preferred stock market. Preferred stocks are a class of capital stock that pays dividends at a specified rate and has a preference over common stock in the payment of dividends and the liquidation of assets. Opinions represented above are subject to change and should not be considered investment advice. This data was prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed.
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Infrastructure Capital Advisors, LLC (ICA) is an SEC-registered investment advisor that manages exchange traded funds (ETFs) and a series of hedge funds. The firm was formed in 2012 and is based in New York City. ICA seeks current income opportunities as a primary objective in most, but not all, of ICA's investing activities. For more information, please reach out to Craig Starr at Craig.Starr@icmllc.com or 212-763-8336.
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The information presented represents our subjective belief and should not be construed as investment advice. The information and opinions provided should not be taken as specific advice on the merits of any investment decision. Investors should make their own decisions regarding any investments mentioned, and their prospects based on such investors’ own review of publicly available information and should not rely on the information contained herein. Infrastructure Capital Advisors, LLC (“ICA”) nor any of its affiliates accepts any liability whatsoever for any direct or consequential loss howsoever arising, directly or indirectly, from any use of the information contained herein. This bio includes information based on data and sources from ICA and third-party sources. We believe that the data is reliable. We have not sought, nor have we received, permission from any third party to include their information in this article. Many of the statements in this article reflect our subjective belief. The comparative illustration provided is for information use only and should not be used for the basis of making an investment decision. All data and sector information are obtained from Bloomberg. Financial Professional Use only. Not for public distribution. Past performance and sector data is not indicative of future results. The links to the fund fact sheets will provide standardized performance and risk disclosures.
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