The Bureau of Labor Statistics’ slightly hotter than expected PPI report sent bond prices tumbling, bringing the 10y US T-Note yield to 4.15%. The ongoing debate of whether the Fed is finally done hiking tilted back, at least for the moment, to the “higher for longer” side of the argument.
This type of sea change warrants a trip back to Portfolio Income Solutions Fixed-to-Floating Preferreds table to see what issues might be emerging as opportunities in this ever changing environment. With the calendar rapidly advancing, our eyes are drawn to Arlington Asset Investment Corp.’s 8.25% Series C Fixed-to-Floating Rate Cumulative Redeemable Preferred (NYSE:AAIC.PC) and its fast approaching redemption/conversion date.
Source: Portfolio Income Solutions
Back in May, we described the arbitrage opportunities we saw in the newly announced merger of Ellington Financial (EFC) and Arlington Asset Investment (AAIC). In the merger, Arlington shareholders will receive 0.3619 shares of EFC and $0.09 cash for each AAIC share. EFC will assume control of the two Arlington preferred stock series, AAIC.PB and AAIC.PC. The preferreds didn’t really factor into the arbitrage play, but with the passage of time and rising interest rates, AAIC.PC has become more compelling.
With only 957,133 shares outstanding and a liquidation preference of just $29.3MM, AAIC.PC is obscure and thinly traded. With patience, a trader can acquire shares at prices that we believe could produce a 13% net return over the next eight months at their 03/30/2024 call/conversion date.
A simple, hypothetical breakdown of a single share purchase might be illustrative.
Over the next three quarters, AAIC is scheduled to pay its fixed, 8.25% coupon dividend. Post 03/30/2024 the shares become callable at their $25.00 liquidation preference or convert to a floating rate coupon of the adjusted 3-month SOFR plus 566.4 basis points. At today’s adjusted SOFR that converts to an 11.29% yield as measured against the $25.00 par value.
The illustration assumes collecting the 3 ensuing fixed-rate dividends and having the shares called on March 30, 2024. This scenario is feasible in that EFC might be able to address the $30MM liquidation preference/redemption with cash on hand. Or, if EFC has access to capital at a cost materially below 11.29%, it would be prudent to call the AAIC.PC.
If the shares are not redeemed, the conversion to floating rate creates a dividend yield of more than 12% against a $23.50 purchase price. If AAIC.PC’s market trading price follows suit to other fixed-to-floating mREIT preferreds that have already converted (AGNC Investment Series C (AGNCN), Annaly Capital Series F (NLY.PF), and Annaly Capital Series G (NLY.PG)) then the shares will trade above par, further enhancing returns.
Arlington Asset Investment Corp. is a micro-cap mREIT that was laid low by the liquidity crisis at the start of the pandemic. AAIC’s preferred issues traded at steep discounts to par but have risen post-announcement of the merger with the larger, presumably stronger, Elliot Financial. EFC is absorbing AAIC and, more recently announced, Great Ajax Corp. (AJX) at prices that reflect discounts to their net equity. If EFC can further amplify returns through synergistic cost-saving efficiencies, then the mergers work to enhance the quality of the capital that supports the preferreds.
While a standalone AAIC inspired significant uncertainties, the merger moves the preferreds to an effectively larger-cap, more investable profile. Buying and selling thinly traded, small cap stocks presents a whole world of risks, but the short calendar to conversion, the high (and maybe higher) dividend yield, along with potential capital appreciation combine to make AAIC.PC an investment risk I am willing to take.