Fear Sends Preferred Stocks Ever Higher

We have lamented the difficulty in buying new issue preferred stocks on the OTC Grey Market at any sort of decent discount to the $25/share issuance price and have been on a mission to determine why these very meager coupon issues are drawing such high demand.

As we have reviewed the available data we have finally concluded there is really a very simple answer.  Fear!!  This is the driver behind the sharp increases in prices of high quality preferred issues (as well as ‘baby bonds’).  If one was to remove the preferred stock issues of energy and shipping companies from the list of over 400 $25/share issues that we follow you would find that values have been ticking up a consistent 1% per month (the average price) for the last 3 months. This is not a “accrued” dividend gain, but simply a month after month gain of 1%. Additionally, the quality new issues that have been sold lately hardly trade below $25 before moving 1-3% higher (excepting Sunstone Hotel Investors 6.95% preferred (NYSE:SHO-E) which moved 8% higher).

What is the fear about?  The primary fear creator is the realization that interest rates don’t keep falling month after month without a cause.  The fear is that investors are going to be stuck having to own treasury bonds with a 1% current yield.  The fear is that a year from now we could have negative interest rates and still have little economic  growth (can you say JAPAN). The reason that quality preferred issues are in such high demand is they are perceived to be the safest high yield available (by high I mean 5.23% or some such number) and new issues give a 5 year protection window for this yield (most preferreds have a 5 year period before they are optionally redeemable).  Any quality issue with a coupon of over 6% will likely be redeemed as we move into another period of sharply lower interest rates. Investors are piling into the new issues to assure themselves of a return than is “adequate” for the next 5 years.

Additional Observations

Investors need to be very careful with preferred and common stocks from the following sectors.  Energy, shipping and mREITs.  It goes without saying that energy and shipping are very dangerous and while we have had a snapback in crude oil prices, short of a larger Middle Eastern war, there is no reason to believe this gain will hold.  Continued crude oil inventory builds and a weak global economy are not recipes for continuing gains.  The shipping sector has mostly a group of poorly managed companies–with a few exceptions such as Costamare (NYSE:CSME) and Seaspan (NYSE:SSW), and many will go bankrupt rendering their preferreds worthless.

mREITs are another story.  Their common and preferred shares weaken and then bounce and weaken and bounce. This is a simply a case of the bloom coming off the mREIT rose.  mREITs really are only decent investments when there is a large spread between the cost of funds and the return on their loan portfolio.  mREITs borrow short and lend long–a classic recipe for disaster in this environment.  A large share of the borrowing of mREITs is 1-90 day “repo” borrowing (the mREIT repurchases the collateral–and normally they then borrow again).  The interest rate charged on repo loans is driven by the Fed Funds rate which has moved higher and of course the mortgage portfolio return is driven by the current mortgage rate and the speed at which homeowners are refinancing to take advantage of ever lower mortgage interest rates.  The spread for the mREIT is narrowing–substantially so.  Today the 15 year fixed rate mortgage hit 2.86% with the 30 year at 3.58% which is the lowest in 3 years and only 23 basis points over the lowest ever.  The Fed Funds rate which has traded as low as near zero since 2010 is now in the 30-50 basis point range. When long rates are falling and short rates are rising you have spread compression and this eventually will wipe out a company.  This is why in the last couple of months mREITs are beginning to merge–it is a merge or die situation.  Armour Residential (NYSE:ARR) has acquired Javelin Mortgage. Annaly (NYSE:NLY) is acquiring Hatteras Financial and Apollo Commercial (NYSE:ARI) is acquiring Apollo Residential Mortgage (NYSE:AMTG).  The companies, to their credit, see the writing on the wall–if the Fed raises Fed Funds a time or 2 yet this year (and who knows for sure) while a weak economy pushes mortgage rates lower the spread will be so slim that they all will be bleeding profusely.  This entire situation will take time to play out–maybe 1-2 years and who knows for sure what will happen in this time frame.  We only caution investors that these securities are not likely long term holdings–maybe they are a “trade” for the adventurous, but if you are conservative you may get more excitement than you care to experience.  Watch for the narrowing (or widening) spread by observing the 10 years treasury and the Fed Funds rate and act accordingly.