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 the 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 third week of January.
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 were roughly flat over the week, despite the continued backup in Treasury yields. Month-to-date, the higher-beta sectors like Tech and BDC (i.e. PSEC.PR.A) have outperformed.
Preferreds yields have now fallen from the recent 8% peak to 7%. This is still relatively high over the last 5+ years as the following chart shows.
Credit spreads, however, are looking quite tight. They now sit at the lower end of their 5-year+ range. The chart also suggests we could easily see a backup in spreads this year, which could offer a better entry point.
Market Themes
CLO Equity CEF Eagle Point Credit Company (ECC) is issuing a new preferred (ECCF, temporary ticker EPCCP). ECC already has 2 other preferreds (ECCC and ECC.PR.D) and it has three bonds (ECCV, ECCW, ECCX).
What’s a bit unusual about the preferreds is that ECCC has a maturity but ECC.PR.D does not. The new ECCF will have a 2029 maturity and an 8% coupon. When the stock was initially priced, we thought it was likely to open weak, given the coupon was below the yield of ECCC and near the yield of the lower-risk ECC bonds. That is indeed what has happened, with the stock opening close to 2% below par.
The table below highlights the key metrics of the three ECC preferreds. With two term preferreds and one perpetual preferred outstanding in the same suite, the situation begs the question of how investors should go thinking about such different types of securities.
There are arguments pointing in different directions, so let’s look at the brief rundown.
One view is that, all else equal, a term preferred is more attractive than a perpetual one. The intuition here is pretty simple. If the issuer ever gets in trouble, the term preferred is better placed than the perpetual one since either all the preferreds default or the company survives long enough to pay out the term preferred, leaving the perpetual preferred in an even worse situation.
Another way to think about this is through market risk. The term preferred has a lower duration profile (which decreases over time to its maturity) as its market sensitivity or duration is limited to its term (barring a default scenario).
By contrast, the perpetual preferred’s duration is extremely high and remains the same. It only goes down if a preferred is likely to be redeemed. By “duration” we are talking about credit duration in addition to interest rate duration, since even a floating-rate perpetual preferred is not immune to large swings in credit spreads. In short, this first view believes that, all else equal, a term preferred is the better choice over a perpetual one.
An opposing way to think about it is that, all else equal, a perpetual preferred may be more attractive, given the yield curve past around 2 years is inverted. In other words, a perpetual security (i.e. one with an infinite maturity) should trade at a lower yield than a security with less than 2 years to maturity. As a technical caveat, what matters more for this analysis is less the Treasury yield curve but rather the high-yield corporate bond credit curve. This curve should be less inverted as corporate credit spreads tend to be upward sloping except for distressed market environments.
Another argument for allocating to the perpetual preferred over the term preferred is that it allows investors to lock in the yield (in the case of a fixed-rate preferred) or the spread (in case of a Fix/Float preferred) “forever”, unless redeemed. A term preferred’s yield, on the other hand, can only generate its yield for so long until its maturity.
In short, this view has it that, all else equal, a perpetual preferred offers investors significant benefits over a term preferred, particularly in the current environment of an inverted yield curve and where longer-term rates could easily keep moving lower as disinflation continues apace.
On net, we tend to side with the first view. The repayment requirement of the term preferred is a key credit enhancement and is the type we would go with, all else equal.
Stance And Takeaways
Among the three ECC preferreds, ECCC offers the best value in our view. More broadly, however, within the CLO Equity CEF senior security space, the best value in our view is in the Priority Income Fund preferreds as the chart below shows.
Alternatively, investors who want to dial down their risk exposure should have a look at the OXLC baby bonds, which are trading above the yields of many of the sector preferreds. We like the OXLC 5% 2027 notes (OXLCZ), trading at a yield of 8.3%.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.