Preferreds Weekly Review: Keep An Eye On The Spread Of Floating-Rate Preferreds

Welcome to another installment of our Preferreds Market Weekly Review, where we discuss preferred stock 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 fourth week of March.

Be sure to check out our other weekly updates covering the business development company (“BDC”) as well as the closed-end fund (“CEF”) markets for perspectives across the broader income space.

Market Action

Preferreds had a good week as Treasury yields fell. The Fed’s lack of significant reaction to a recent run of stubbornly high inflation was viewed positively, with markets rallying nearly across the board.

Preferreds spreads have now moved below 1% – the tightest level in the post-COVID period.

The drop in both Treasury yields and spreads means yields continue to march lower, making the sector much less favorable for new capital allocations.

Market Themes

Most investors know full well that the coupons of floating-rate preferreds will step down once the Fed starts to cut rates (technically, they will step down once the market is convinced of a cut as the typical base rate of 3-month term SOFR is a forward-looking rate).

However, there is also a second-order driver of coupons which is the spread over SOFR of any given preferred. The spread level is the fixed portion of the floating-rate coupon (being SOFR + fixed spread) and it is only the SOFR component that will drop. Although the level of the spread does not determine the absolute coupon change, it does determine the relative coupon change, i.e., the change in the coupon relative to its previous level.

For example, the chart below shows the relative change in SOFR + 1% and SOFR + 5% coupons after a 0.75% drop in SOFR, roughly what is penciled in over this year by the Fed in the latest dot plot.

Intuitively, this difference is there because, for the lower spread stock (i.e., SOFR + 1%), the floating component (i.e., SOFR) is much larger than the fixed component (i.e., 1%) so its drop has a greater impact on the overall coupon (again, in relative, not absolute terms). We can see this in the absolute coupon levels below.

Why is this relevant? There are two factors to consider – one is the actual change in coupon in both absolute and relative terms, and two, the potential impact on the price of the stock. On the first point, the coupon of the low-spread preferred will drop “faster” than that of a high spread preferred. And on the latter point, the price of the low-spread stock could also drop faster than that of a high-spread stock.

Floating-rate preferreds are often assumed to be invulnerable to changes in base rates as they have no duration and that is how it tends to play out in the institutional market with securities like CLOs or bank loans. However, in the retail market things are a bit different as investors can easily rotate into fixed-rate preferreds whose coupons could rise above their floating-rate counterparts in a sharp drop in base rates, pushing down the price of floating-rate preferreds for technical reasons.

In our view this is less of a concern this time around as the path of rate cuts should be much slower than it was in 2020 and long-term rates are not expected to jump lower alongside base rates (as they did in 2020, boosting the price of longer-duration instruments like fixed-rate preferreds). The yield curve is also unusually inverted, something which supports floating-rate preferreds of all spread levels.

That said, investors should evaluate whether their low-spread floating-rate preferreds holdings will make sense over the coming year. This includes preferreds such as a number of Goldman Sachs stocks, USB.PR.A, MS.PR.A, MET.PR.A, SLMBP, and others. We continue to hold some of these preferreds as they offer a significant yield cushion even in the case of several cuts by the Fed but they are on a short leash.

Stance And Takeaways

This week we rotated into the recently issued bond from Athene – the 7.25% 2064 subordinated debentures (ATHS). The bond has a yield-to-worst of around 6.9% which happens to be above all of its preferreds though some could see a step-up in yield down the road unless redeemed. This switch to an up-in-quality and longer-duration security is a response to the trend in lower spreads over the past year.