Preferreds Weekly Review: Year-End Tax Losers Rally Hard

This article was first released to Systematic Income subscribers and free trials on Jan. 8.

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 first 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 had a terrific start to the year with some sectors rallying by more than or close to double-digits. Higher stocks and lower Treasury yields fueled the rally, in expectation of a dovish pivot by the Fed.

This short-lived January has already erased all of the December drop and is on par with earlier strong months of July and November.

Preferred yields fell back to a 6% level from their highly attractive 6.5+% levels last year.

Preferreds outperformed Treasuries as credit spreads tightened by around 0.15%.

This made preferred the second-best performing sector of this young year.

Market Themes

Over the last few weeks we have seen a common theme played out once again in the preferred space. Many stocks continued to fall into year-end but bounced sharply once the year began.

A good example of this pattern is the Brookfield Property Partners Series 3 (BPYPN) which had a V-shaped return profile over December and into January.

Some of this behavior is clearly due to broader factors such as moves in Treasuries and the beta of individual stocks; however, the credit spread chart above shows that preferred underperformed Treasuries in December and outperformed in January, meaning there is something more going on here than just broader markets.

This sort-of supercharged performance is likely due to tax-loss selling weakness in December and new interest in beaten-down stocks once tax-loss selling pressure was lifted in the new year.

The chart below shows that it was the most beaten-down stocks of 2022 that also enjoyed the highest bounce.

This kind of pattern suggests two things. Investors who want to harvest tax-loss selling in a down year may want to do it prior to December – a time when many other investors will be selling in an environment of steadily lower liquidity. And two, it can make sense to allocate to securities close to the end of December or right at the beginning of the new year once most of the tax-loss selling smoke clears.

Investors can also avoid the wash sale rule and buy back the same securities if they sell in November and buy back in January – across a period of more than 30 calendar days.

The institutional preferreds market can be a good place to rotate spare capital until the end of the year for investors who are uncomfortable sitting on cash. Institutional preferreds don’t have the kind of seasonality that retail / exchange-traded preferreds do. For instance, the institutional preferred fund (FPEI) was roughly flat in December while the retail-focused PFF dipped in December and then rallied hard in January.

Preferred Tool Update

This week we updated our Preferreds Tool to provide a better representation of forward yields for non fixed-rate stocks. The chart below shows expected yields based on current interest rate forwards for stocks with various coupon types:

RITM.PD – 5Y CMT coupon starting in Nov-2026, unless redeemed NYMTL – SOFR coupon starting in Oct-2026, unless redeemed NLY.PF – 3M Libor – based coupon (which will eventually switch to SOFR) right now

The chart shows that the RITM.PD coupon remains flat for 5 years after its reset in 2026 until its next reset 5 years later. The coupons of the other 2 stocks continue to reset quarterly after their own first call date.

This kind of representation can make it easier to compare different stocks to each other – not just at today’s yields but also at likely yields in the future.

Stance And Takeaways

We continue to hold a diversified portfolio of preferreds and baby bonds across sectors, coupon types and quality/yields. We see value in shorter-maturity decent quality fixed-rate bonds such as AIC and OXSQL trading at 9% and 7.8% yields respectively. Both have held up extraordinarily well in 2022 and have served their purpose as high-yielding ballast.

We also like floating-rate preferreds such as AGNCN and NLY.PF which will continue to deliver rising income levels towards a 10% level when the Fed is expected to pause. We don’t expect a sharp turnaround by the Fed so these preferreds will remain attractive this year.

Finally, longer-duration / very high-quality preferreds such as the CEF preferreds ACP.PA and OPP.PB with 6.1-6.2% yields can outperform in case of a hard landing this year.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.